Foreign Exchange and Disaster Risk Management in Microfinance Institutions


Master's Thesis, 2008
89 Pages, Grade: 1,00

Excerpt

TABLE OF CONTENT

TABLE OF FIGURES

TABLE OF ABBREVIATIONS

1 INTRODUCTION
1.1 ECONOMICS OF MICROFINANCE INSTITUTIONS
1.2 OVERVIEW ABOUT THE FOLLOWING CHAPTERS

2 RISK IDENTIFICATION AND ASSESSMENT
2.1 OVERALL RISK MAPPING IN MFIS
2.2 A NALYSIS OF DISASTER - RELATED RISKS
2.2.1 INTRODUCTION TO DISASTER RISKS
2.2.2 DISASTER-RELATED RISK MAP
2.2.3 ASSESSMENT OF DISASTER-RELATED RISKS
2.3 A NALYSIS OF FX- RELATED RISKS
2.3.1 INTRODUCTION TO FX RISK
2.3.2 FX-RELATED RISK MAP
2.3.3 ASSESSMENT OF THE RISKS IDENTIFIED
2.3.4 EXCHANGE RATE SYSTEMS AND DOLLARIZATION
2.4 MOST COMMON TREATMENT FOR FX AND DISASTER ISK

3 DISASTER RISK MANAGEMENT
3.1 INSTITUTIONAL DISASTER PREPAREDNESS
3.2 TRIGGER CONCEPTS AND PREREQUISITES FOR THE RISK TRANSFER
3.3 EVALUATION OF EXISTING FINANCIAL INSTRUMENTS
3.3.1 CATASTROPHE BONDS
3.3.2 WEATHER DERIVATIVES
3.3.3 CONTINGENT CAPITAL / CONTINGENT CREDIT
3.4 TACKLING DISASTER RISK ON HIGHER OR LOWER LEVELS
3.4.1 DISASTER-MICROINSURANCE
3.4.2 DISASTER LOAN FUNDS
3.4.3 PUBLIC-PRIVATE-PARTNERSHIPS

4 FOREIGN EXCHANGE RISK MANAGEMENT
4.1 SUSTAINABLE RISK ACCEPTANCE
4.2 RISK A VOIDANCE STRATEGIES
4.3 RISK MITIGATION STRATEGIES
4.3.1 CURRENT PRACTICES: OPERATIONAL HEDGES
4.3.2 EVALUATION OF FINANCIAL INSTRUMENTS
4.4 INNOVATIVE CONCEPTS

5 CONCLUSION

APPENDIX I Value at Risk ZAR-USD 5-year analysis APPENDIX II Degrees of Dollarization (1996 – 2001) APPENDIX III Memo Trueb, J., August 19, 2007

APPENDIX IV Overview about FX risk management strategies

APPENDIX V Memo Zuidberg, J., September 19, 2007

BIBLIOGRAPHY

A) Non digital sources
B) Digital sources TABLE OF INTERVIEWS

TABLE OF FIGURES

Figure 1: Average loan size / GNI per capita Source: Microfinance Information Exchange, Inc. (MIX), based on the 2005 Benchmarking

Figure 2: Breakdown of specialised MFIs Source: Meehan, J. (2004), p.3 (modified)

Figure 3: MFI Risk Map Source: self-provided

Figure 4: Great Natural Catastrophes 1950-2003 Source: http://www.ourworldfoundation.org.uk (05.08.2007)

Figure 5: Indian Climatic Disaster Risk Map Source: http://commons.wikimedia.org (05.08.2007)

Figure 6: Hazard modeling (left) and Loss estimation (right) Source: N.p., World Bank (2006), pp.36-37 Page: 10

Figure 7: Liquidity flow during a disaster Source: self-provided

Figure 8: Liquidity needs distribution Source: N.p., World Bank (2006), p.37 (modified)

Figure 9: Value at Risk of the South-African Rand Source: self-provided Data : http://www.oanda.com/convert/fxhistory (03.08.2007)

Figure 10: Payout calculation for multiple hazard events Source: N.p., World Bank (2006), p.42

Figure 11: Application ranges Source: N.p., USAID-OAS (1999), Relationship of Return Period to Annual Probability Distribution of Extreme Wind (modified)

Figure 12: Layering instruments Source: Self-provided on the basis of: N.p., World Bank (2006), p.37

Figure 13: Cost of debt with diversified local currency funding Source: Zuidberg, J. (2007), p.6

Figure 14: Overview about FX risk management strategies Source: self-provided

Page: APPENDIX IV

TABLE OF ABBREVIATIONS

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1 Introduction

1.1 Economics of Microfinance Institutions

Microfinance institutions (MFIs) have been largely regarded as instruments of donor associations for the altruistic distribution of money in developing countries. In fact MFIs are commercial lending institutions to be found all over the world – in developing and developed countries likewise – that have partly been co-financed by donors as their business model supports some charitable goals like the reduction of poverty. Since MFIs become more and more profitable and their portfolio sizes as well as their numbers of borrowers are growing by up to more than 50% annually, MFIs increasingly seek for additional commercial funding sources – both locally and internationally.[2] This increasingly enforces their self-responsibility for economical sustainability including a prudential treatment of existing and emerging risks.

The basic principle in credit risk management is that a loan has to be secured by collateral. This initiates a vicious circle that has often been interpreted as “the more you got the more you get” with the consequence that people who got nothing at all will not get any start-up capital to change this state. When Muhammad Yunus, the Nobel Peace Prize laureate of 2006, founded the first microfinance institution in 1976 in Bangladesh, his idea was to overcome this basic rule in banking with a leap of faith that initiated ongoing client relationships.

Today there are around 10,000 MFIs providing micro-loans to poor people and small enterprises reaching repayment rates up to 100%.[3] The global loan portfolio is estimated 7 billion US-Dollar (USD) in outstanding loans, serving around 13 million clients, and generating repayment rates of 97% in average. Since loans were formerly provided to potential micro-entrepreneurs to set up small businesses, they created assets broadening the demand for additional services. To date the range in some MFIs comprises additional services as checking and saving accounts, insurances, transfer services, remittances and even leasing contracts, while the majority still focuses on loans and deposits. The diversity of organisations, products, methodologies, clients and geographical locations exacerbates a clear definition of MFIs. The Microfinance Information Exchange Inc. (MIX) defines MFIs according to their size as financial institutions whose average balance of services is not greater than 250% of the average income per person in the country.[4] illustration not visible in this excerpt

Based on this definition MIX conducted a survey in 2005 analysing 446 MFIs in the Middle East and North Africa (MENA), Asia, Latin America and the Caribbean (LAC), Eastern Europe and Central Asia (ECA) and Africa finding that the average loan size ranges from 15% to 90% of the GNI per capita. (See figure 1 on the right) MFIs in this segment often provide micro-loans between only 10 and 100 USD of value. Interest rates for these loans range from 30% to 80% plus commissions and fees to provide loans on a cost recovery level and survive in the long-term because MFIs are subject to significant higher costs for transaction, risk cover and refinancing than traditional banks in other sectors.[5] The provision of micro-credit is very time-consuming and resource intensive since the customer base is multiple times broader and borrowers make repayments monthly, or even more frequently. Thus according to the MicroBanking Bulletin 2006 the average expense ratio of MFIs around the globe is 24.9%.[6] Nevertheless micro-entrepreneurs are able to afford these high interest rates as they are only a small percentage of their total returns. Studies in India, Kenya and the Philippines computed an annual return on investment by micro-businesses between 117% and 847%, which are seen as commonplace.[7] Compared with the alternative of informal moneylenders in the black market which are charging monthly interest rates up to 100%, the official rates in MFIs are even comparably low.

illustration not visible in this excerpt

Figure 1 : Average loan size / GNI per capita

Source: Microfinance Information Exchange, Inc. (MIX), based on the 2005 Benchmarking

illustration not visible in this excerpt

Figure 2: Breakdown of specialised MFIs Source: Meehan, J. (2004), p.3 (modified)

Today’s MFIs have diverse legal states from Non-Governmental Organisations (NGOs) to credit unions, regulated financial companies and specialised banks strongly determining their product ranges and refinancing abilities.[8] The biggest differences result from the institution’s size and level of development. While some MFIs as Compartamos in Mexico or ASA in Bangladesh are regulated institutions with portfolios of outstanding loan amounts of up to 255 million USD, other MFIs emerged out of neighbourly help and are still in an early stage of development.[9] Figure 2 illustrates an estimation of the market participant’s distribution concerning their different stages of development. Apart from the leading group of mature institutions MFIs are considered to be small with gross loan portfolio amounts of less than 2 million USD and big if the value exceeds 15 million USD.[10] Profitability is likewise correlated with stage of development and size. “[…] 63 of the world’s top MFIs had an average rate of return of about 2.5% of total assets, after adjusting for inflation and after taking out subsidies programs might have received.”[11]

1.2 Overview about the following chapters

Chapter 2 will enter the subject with an overall risk mapping in MFIs. In the following “disaster” as well as “foreign exchange” (FX) risk will be introduced separately. The concrete impacts from their different peculiarities will be pointed out and analysed in an exemplarily risk assessment. The chapter ends with a short insight in the common treatment of such “high impact – low frequency”-risks in developing countries and the aspect of the Samaritan’s dilemma to underline the importance of rethinking about current practices. To handle the overwhelming diversity of the examined field, this work will focus on the usual business model of MFIs offering loans and saving accounts to their clients and the financial dimension of the concerned risks.

The third chapter shortly describes the initiation of institutional disaster preparedness as essential prerequisite for all following activities concerning disaster risk management. General basics for the transfer of disaster risks will be discussed isolating the most appropriate instruments. Chapter 3.3 introduces three financial instruments from the group of alternative risk financing and discusses their applicability for MFIs individually. To overcome the identified hurdles, three alternatives will be pointed out enabling the usage of the instruments described before.

Chapter 4 explains the concept of faithful risk acceptance as a framework for risk management considering influenceable risks as those arising from foreign liabilities. In a second step the different strategies of risk avoidance will be presented. Chapter 4.2 discusses instruments and strategies to minimise or transfer foreign exchange risk from international liabilities concerning applicability, effectiveness and efficiency in the microfinance context. This includes operational hedges and bilateral agreements as well as financial instruments as they are formerly used in more developed economies. Finally innovative concepts as “The Currency Exchange Fund” will be presented as new opportunities for MFI’s risk management of foreign exchange risks in developing countries.

Even though MFIs settled as well in developed countries like Germany, this work will focus on the vast majority of MFIs in developing countries to take regional specifics like underdeveloped financial markets and volatile exchange rates more into account.

The thesis ends in chapter 5 with a summary of the key findings and an evaluation of current possibilities. General constraints to effective risk management in MFIs will be highlighted describing possible future prospects.

2 Risk Identification and Assessment

2.1 Overall Risk Mapping in MFIs

The first step in the risk management process is to become aware of existing and emerging risks. All risks have to be identified and understood to assess their impact on the institution. The business model of MFIs is very similar to that of commercial banks, hence is creating an akin risk map. illustration not visible in this excerpt

Figure 3: MFI Risk Map Source: self-provided

Since for many MFIs lending is the core business function, default risks from the inability to collect interest and/or principals from the micro- entrepreneurs are the most frequently discussed risks in this context. Many successful strategies like group lending and family loans have been developed over the past years reducing this risk in well-managed institutions up to 100%.[12] Reputational risk is important because many clients have few experiences with financial institutions, and a negative image can influence the client’s confidence particular in reference to savings and deposits. Liquidity risk is becoming more and more crucial as the majority of maturing MFIs start to offer saving and even checking accounts to their clients. The fact that they are predominant located in emerging countries which are heavily exposed to natural disasters and economic instabilities, highlights the operational risk from external events and stresses the liquidity risk additionally. Out of the market risks especially interest rate and foreign exchange risks are growing due to the fact that MFIs often borrow at floating rates and increasingly Krauss and Walter [Krauss, N., Walter I. (2006)] calculated a median default rate for 283 MFIs of 2.4%. in foreign currencies. Their loans are largely offered at fixed interest rates in domestic currencies – this leads to a dangerous asset-liability- mismatch. The increasing refinancing in hard currencies in absence of proper risk management practices is currently considered to be one of the biggest threats to microfinance institutions on the way to an independent business establishment.

2.2 Analysis of Disaster-related Risks

2.2.1 Introduction to Disaster Risks

The United States Department of Commerce defines a disaster as “a crisis event that surpasses the ability of an individual, community, or society to control or recover from its consequences.”[13] Accordingly, the classification as disaster is dependent on the magnitude of an event and the individual vulnerability of the MFI and its clients.

The causes of disasters can be differentiated in natural and man-made hazards with significant negative impact on the society or the environment. Frequency and severity of natural disasters worldwide increased exponentially in recent years. Due to multiple reasons areas, that faced infrequent natural disasters in the past, may experience more frequent floods, droughts and hurricanes in the future as can be seen in figure 4. (The thin black line is demonstrating the overall trend in natural disaster’s frequency.) illustration not visible in this excerpt

Figure 4: Great Natural Catastrophes 1950 - 2003

Moreover MFIs operate predominant in developing countries which are exceptional prone to natural disasters such as earthquakes, floods, tsunamis, droughts, hail, frosts, volcanic eruptions or hurricanes. “Between 1990 and 1998, 94 percent of the world’s 568 major natural disasters and more than 97 percent of all natural disaster-related deaths were in developing countries”.[14] A self-conducted analysis including all disasters worldwide with more than 10,000 people affected between 1997 and 2007 confirmed this result concerning the disaster locations.[15] Furthermore, the vulnerability of MFI’s clients in developing countries is exorbitant high due to their establishment in cheaper less disaster-protected areas, simple accommodation facilities and the strong dependence on agricultural business. The latter is seen as engine for a big share of the micro-businesses because even non- agricultural jobs are closely related to agricultural production and have little capacity to grow on their own.[16] As a matter of fact even less catastrophic events as heavy rainfall or drought can severely affect a MFI’s client base and result in a disaster according to the afore mentioned definition.

The eventualities of man-made disasters are infinite, ranging from technological disasters (e.g. engineering failures, transport accidents) to sociological disasters (e.g. crime, terrorism, riots or war), and can hardly be foreseen or managed from the point of affected organisations or companies.

Economic or financial crises can result from man-made events as overwhelming public debt or from natural disasters and their consequences. Investigations in the impact of macroeconomic distress showed weak correlation between the macroeconomy and the net operating income of MFIs. This can be explained with the circumstance, that MFI’s clients “may be less integrated into the formal sector of the economy”.[17] The Bank Rakyat Indonesia, for instance, was forced to write off 100% of its corporate portfolio and 50% of its middle market loans during the Asian financial crisis – in its microfinance portfolio on time repayment slid only one percent to 97.5%.[18] Beside the marginal impact on client’s businesses, a financial crisis can have profound consequences on a MFI’s refinancing activities that will be discussed in chapter 4 as a dimension of the foreign exchange risks.

Further remarks of this chapter will concentrate on the most likely derivation of disastrous situations for MFIs, which are severe weather events and natural disasters with a special focus on developing countries.

2.2.2 Disaster-related Risk Map

A natural disaster, regardless its nature, can affect MFIs in three major risk categories.

Operational risk arises from the direct interruption of operational activities through physical damages, e.g. the destruction of offices, equipment or information systems, or through indirect implications like the inability to reach offices and clients or damages to the overall infrastructure. Reputational risk can arise from an institution’s inability to fulfil its contractual obligations in the aftermath of a disaster, e.g. to disburse deposits to savers.[19] Additionally, the risk of fraud and theft is often designated to be increased in crisis situations.

Credit risk increases significantly by death or disability of micro- borrowers. Even physical unscathed borrowers may be inhibited to attain earnings and pay interest or principles because of destroyed livelihoods or injured family members. This can have severe impact on the liquidity situation of a MFI.

Liquidity risk is furthermore tightened by missing savings and immediate withdrawals of existing deposits to replace lost livestock or afford medical care. Those who are not in possession of deposits will probably demand emergency loans, whether they are already existing clients or non-clients.

2.2.3 Assessment of Disaster-related Risks

illustration not visible in this excerpt

Figure 5: India Climatic Disasters Risk Map

Source: http://commons.wikimedia.org (05.08.2007)

Assessing disaster risks, the possible hazards have to be identified for every area the MFI operates in. Historical data about frequency and severity of past events has to be collected from governments or insurance companies. Figure 5 shows a risk map of climate-related natural disasters exemplarily for India, exhibiting domestic hazard-prone areas for cyclones, floods, droughts and hot or frigid deserts.

Hazard modelling transforms the data into hazard probability distributions for every possible threat.[20] This can be done using historical or Monte Carlo simulations. The probability is often described in terms of “1 in X years” instead of percentages as can be seen in figure 6. Since damage and loss increase exponentially with the intensity of a disaster, the loss estimation shows the relation of the severity of the hazard and the expected damage. The inherent damage function describing this relation is specific to the infrastructure and the building types in the concerned territories and the particular level of disaster preparedness. illustration not visible in this excerpt

Figure 6: Hazard modelling (left) and Loss estimation (right) Source: N.p., World Bank (2006), pp.36-37

The loss estimation shows the direct impact on clients but can be used to assess the MFI’s operational risk in terms of physical damages to buildings and infrastructure as well.

The increase in credit risk can be estimated from historical damage levels and correspondent increases in default rates or repayment delays. Experiences of 24 MFIs in India documented the direct impact of the Bangladesh flood in 1998 pointing out that 43% (of 39,354 borrowers) discontinued repayments after the disaster resulting in a liquidity shortfall of 31.9%.[21] A similar investigation in Pakistan analysed repayment rates between 1994 and 2006, and reported that after the earthquake in 2005 delays in affected areas increased by even 52% in contrast to unaffected areas.[22] A relation between these figures and the correspondent water levels respectively magnitudes can describe the credit risk in dependency on the disasters severity.

To assess the overall liquidity risk similar calculations have to be performed for all cash flows. “Liquidity needs, to the extend possible, should be estimated on the basis of worst-case scenarios”.[23] The MFIs mentioned before noted that 52.1% (of 93,621 savers) discontinued making regular savings leading to an additional decline in liquidity of illustration not visible in this excerpt

Figure 7: Liquidity flows during a disaster Source: self-provided

The provision of emergency loans is seen as crucial for the recovery of micro-entrepreneurs and would have to be added to the existing cash flows. Nevertheless, this factor can be excluded from the risk assessment thus it reflects no direct obligation for payoffs. Taking all these changes in cash in- and outflows into consideration, the need for additional liquidity can be estimated in dependency on the severity of a disaster as shown in figure 8. The vulnerability of an institution’s liquidity situation will finally depend on the quality and diversification of its loan portfolio and the extent to which it has relied on savings to fund loans. Especially in Africa, MFIs recycle the savings of their clients as a principle source for loans.[25] In Bangladesh from a total of 3,225,000 affected clients can be stated that MFIs needed 45 USD per affected client to meet the liquidity needs in a major natural disaster.[26] This is naturally in other countries depending on the respective loan size, per capita income and a range of other factors.

illustration not visible in this excerpt

Figure 8: Liquidity needs distribution

Source: N.p., World Bank (2006), p.37 (modified)

2.3 Analysis of FX-related Risks

2.3.1 Introduction to FX Risk

The entire market demand for microfinance services is estimated between 150 and 300 billion USD, while market supply is currently just 4 billion USD.[27] Donors, which have been the main funding source in the past, contribute only 1.2 billion USD and keep their engagement stable. International capital markets are seen as auspicious source to close the funding gap. Microfinance has low correlation to domestic and international economic cycles and margins are comparably high.[28] Furthermore, interest rates for hard currency loans are lower than those of domestic banks, which is according to the CGAP-MIX survey 2004 the most important reason for MFIs to seek foreign investment regardless of the local availability.[29] Currently 505 MFI have received foreign investment.[30] The primary sources are international financial institutions, which increased their MFI investment by 121% during 2003 and 2004, and social-responsible funds leading to a total of 2.72 billion USD foreign debts in the microfinance market, which is 16% of the overall funding.[31] Due to this, the Standard & Poor’s rating methodology for MFIs pays special attention to exchange risks and employed hedging instruments when they are composing ratings.[32]

2.3.2 FX-related Risk Map

Foreign exchange risk in MFIs arises from refinancing in other countries and must be considered in three different peculiarities.

Depreciation risk emerges from “a gradual decline in the value of a currency in comparison with another currency.”[33] Because the majority of MFIs lend in domestic currency to their clients a foreign-currency- denominated debt increases significantly if the value of the domestic currency declines over the time.

Devaluation risk is defined as an extreme of the latter in the form of a “sharp fall in the value of a currency in comparison with another currency.”[34] This can be due to economic or financial crises as experienced in the “Mexican Tequila Crisis” between 1994 and 1995, the “Asian Crisis” between 1997 and 1998 and the “Tango Crisis” in Argentina in 2001 and 2002, or following natural disasters. The latter reduces earning capacities narrowing a country’s tax base, while its spending needs rise.[35] To meet obligations, external public debts have to increase. A weakened production capacity and post disaster reconstruction can lead to a demand-driven hyperinflation and boosts imports from foreign countries. In combination with a withdrawal of worried foreign investors this puts downward pressure on the exchange rate, which, in extreme cases can be leading to currency devaluation.

Convertibility and transfer risk refers to the fact that a “government will not sell foreign currency to borrowers or others with obligations in hard currency” (convertibility) or “will not allow foreign currency to leave the country” (transfer).[36]

Some authors count interest rate risk from foreign liabilities to the wider circle of foreign exchange risk. Due to only slight differences to the interest rate risk in domestic finance this peculiarity will not be discussed separately in this work.

2.3.3 Assessment of the Risks identified

The global FX market by far is the largest financial market in the world with an average daily turnover of more than 1.2 trillion USD.[37] Supply and demand in this market are determined by changes in many market variables, like the relative price levels, real interest rates, productivity, and perceptions of economic stability thus the traded exchange rates change every day.

An analysis of Women’s World Banking (WWB) based on International Monetary Fund data stated that 23 emerging country currencies depreciated in a simple 5-year average 7.8% against the USD.[38] To assess the risk of an institution’s foreign-currency-liability, the respective cross rate has to be analysed. “The most popular methodology for this first step is to apply a value-at-risk (VAR) measurement.”[39] A self-conducted 5-year analysis of the South-African Rand’s exchange rate against the USD resulted in a possible maximum depreciation of 54.17% and an accordant Value-at-risk at 99% confidence level of 50.83% as shown in the following figure.[40] illustration not visible in this excerpt

Figure 9: Value at Risk of the South African Rand Source: self-provided

Data: http://www.oanda.com/convert/fxhistory (03.08.2007)

This means that a South-African MFI has to allocate 50.83% (/46.38%) of the principle amount of an USD-denominated 5-year loan in risk- based capital to ensure a 99% (/90%) confidence level regarding the inherent depreciation risk. An estimation of the institution’s overall FX risk exposure would have to apply such a scenario and further stress tests on the quotation of foreign liabilities to risk based capital, e.g. the institution’s equity.[41]

[Example: FX risk exposure at 99% confidence level (5 years) = (FX assets – FX liabilities) * (1 + 0.5083) / equity]

The devaluation risk, which goes mostly hand in hand with the convertibility and transfer risk, can hardly be calculated on a monetary basis. The possible causes of natural disasters have already been discussed in the last section. For the causes of economic imbalances in a country, it is necessary to conduct a macroeconomic country risk analysis, which consists of a political and an economical view.[42] Several qualitative factors have to be evaluated and weighted leading to a country risk value that gives an impression of the individual country risk in comparison with other countries. An individual observation of the containing factors in connection with threshold levels can serve as an early warning system for imminent economic crises. Early warning systems of a country’s overall situation include factors like the exchange rate in real terms, the current account balance, the government’s external debt, the foreign exchange reserves and the budget balance.[43] The real exchange rate is an indicator for an overvaluation of a currency and possibly leading to a slowdown in export growth. The resulting current account deficit has to be balanced by the financial account in form of capital inflows. In combination with too little foreign exchange reserves it can lead to currency depreciation. These imbalances can turn into a crisis when international investors begin to withdraw their capital.

2.3.4 Exchange Rate Systems and Dollarization

While most emerging countries are very exposed to depreciation or devaluation risk, some are less or not at all concerned. One reason can be the chosen exchange rate system. In a system of flexible exchange rates (e.g. U.S.A.) the value is completely determined by demand and supply of that currency on the spot markets. An increased demand in goods of the considered country leads to an increased demand for money in the correspondent currency to buy the goods which in the follow leads to an increased value against other currencies. A fixed exchange rate system on the other hand is characterised by active supply of money by the country’s central bank [e.g. Panama (USD), Bosnia-Herzegovina (EUR)]. An increased demand in money on the spot market will then be counteracted by corresponding supply of money to keep the value stable. Every state in between in form of an occasionally intervention of the central bank is called managed floating. A fixed exchange rate system reduces the risk of depreciation to nearby zero. Since foreign exchange reserves are limited, the devaluation risk cannot be eliminated – especially not in developing countries where exchange rates are very vulnerable to speculation.[44] Because a fixed currency may not represent their true market value, it can become subject to increased speculation tightening the risk of devaluation. During the “Asian Crisis” (1997/1998), Thailand, the Philippines, Indonesia and South Korea abandoned the defence of their currencies soon after the dramatically fall of asset values.[45]

A linked exchange rate is given when a government assures the exchange of a certain foreign currency or another measure of value, such as gold, to the domestic currency in a constant rate [e.g. People’s Republic of China (USD) or the U.S.A. from 1944 to 1971 (gold)]. As long as such a mechanism is adhered, there is no foreign exchange risk between these two currencies, but market participants have to pay heightened attention to a possible decoupling of the currency, as it was the case after the “Nixon shock” in the U.S.A. in 1971.

Another reason for the absence of foreign exchange risk is dollarization. “Full dollarization occurs when a country abandons its own currency and officially adopts a foreign currency […] as its predominant or exclusive legal tender for all financial transactions” (e.g. Panama, Ecuador, El Salvador – all three USD).[46] Partial or “unofficial” dollarization is given when people hold large amounts of foreign currency as deposits or notes for use as payments, while wages or taxes are still paid in local currency. A high level of partial dollarization is existent in Bolivia (USD), Paraguay (USD), Peru (USD) or Bosnia- Herzegovina (EUR).[47] The level of dollarization is inversely related to a MFIs currency risk – a high degree of dollarization results in a low depreciation or devaluation risk in relation to this currency. This means in reverse that countries with very low dollarization (e.g. South-Africa,

Taiwan, Colombia) are particularly at risk.

For a list of developing country’s degrees of dollarization see APPENDIX II

Nevertheless, it is important to make aware that even in systems with fixed exchange rates or high dollarization the risk for any other currencies than the one concerned remains unchanged and that unofficial dollarization is still no protection against convertibility or transfer risk.

2.4 Most common Treatment for FX and Disaster Risk

To date, from the microfinance industry’s perspective fortunately all considerations concerning massive currency devaluation are “possible maximum loss”-assumptions because they have not yet experienced crashes due to foreign-currency-denominated liabilities.[48] Commercial foreign debts emerged significantly in recent years and were still minimal during the last major currency crises. Supposedly for that reason, “almost without exception, it is the MFI that accepts the risk of currency depreciation.”[49] It is alarming that the microfinance industry has largely chosen to ignore this accepted risk.[50] A survey of MFIs indicated that 50% of them had nothing at all in place to protect them from foreign exchange risk resulting in increased default risk.[51] Protection against disaster risk shows a similar picture. In general, developing countries “[…] have made fewer efforts than developed countries to adapt their physical environments to mitigate the impact of natural disasters, or to insure themselves against disaster risk.”[52] “In developing countries, market research for insurance products indicates that poor households are not interested in being protected against all risks.”[53] The analogy between the treatments of these two “high impact – low frequency”-risks may be explained by an instance called the “Samaritan’s dilemma”. It describes the disincentive of potentially decreasing support from government, the World Bank or foreign donors when damages have been mitigated by the purchase of protective measures in advance.[54] A factor that has been fostered by the World Bank itself through forgiveness of loans to MFIs in case of financial or natural disasters.[55] However, private, commercial lenders will not maintain this policy as long as their motivation to invest in microfinance is predominant commercial and not altruistic. International investors like microfinance funds largely choose to minimize their risk by very limited provision of local currency loans, financial hedging instruments or the creation of local currency risk funds. However for the MFI the increased risk of default due to the inability to meet its financial obligations in the aftermath of natural or economic disasters remains unchanged.

[...]


[2] Cp. Coppoolse, M. (2007), p.2

[3] Cp. in the following N.p., UNCDF (2007)

[4] Cp. in the following N.p., Microfinance Information Exchange (2007)

[5] Cp. Fernando, N.A. (2006), pp.1-3 as well as N.p., MicroCapital (2006), p.1

[6] Cp. N.p., MicroBanking Bulletin (2006), p.33

[7] Cp. N.p., International year of microcredit 2005 (2007), p.1

[8] Cp. Bruett, T. (2004), p.1

[9] Cp. Coppoolse, M. (2007), p.2

[10] Cp. N.p., MicroBanking Bulletin (2006), p.29

[11] Cp. N.p., The MIXmarket (2007)

[12] Cp. N.p. responsibility (2005), p.2

[13] Source: http://www.ourworldfoundation.org.uk/dis-nof.htm#3 (05.08.2007)

[14] N.p., World Bank (2000), p.170 Note: A disaster is classified as “major” if it caused more than 50 deaths or affected more than 100,000 people. (Source: USAID, OFDA 1999)

[15] The analysis included 1184 events worldwide whereof 1114 took place in developing countries (=94%). Source of data: EM-DAT: The OFDA/CRED International Disaster Database - www.em-dat.net - Université Catholique de Louvain - Brussels - Belgium

[16] Cp. Skees, J. et al. (2002), p.2 and 3

[17] Cp. Krauss, N., Walter I. (2006), pp.12 and 13

[18] Cp. Meehan, J. (2004), p.15

[19] Cp. in the following Pantoja, E. (2002), pp.13 - 15

[20] Cp. in the following N.P., World Bank (2006), p.36

[21] Cp. N.p., Global development research center (n.d.), p.2

[22] Cp. Khan, H.D., Kurosaki, T. (2007), p.8

[23] Pantoja, E. (2002), p.38 29.4%.24 Other income declined by 35% resulting in an overall decline in cash inflows of 31.8%. Cash outflows increased even more dramatically. Grameen Bank reported that 95% of compulsory savings were withdrawn during the disaster.

[24] Cp. in the following N.p., Global development research center (n.d.), p.2

[25] Cp. N.p., UNCDF (2007)

[26] Cp. N.p., Global development research center (n.d.), p.2

[27] Cp. Krauss, N., Walter I. (2006), p.3; Meehan, J. (2004), p.1

[28] Cp. Krauss, N., Walter I. (2006), p.10-12

[29] Cp. N.p. CGAP Focus Note No.30 (2005), p.9

[30] Cp. N.p. CGAP Focus Note No.30 (2005), p.1

[31] Cp. N.p. Standard & Poor’s (2007a), p.2

[32] Cp. N.p. Standard & Poor’s (2007b), p.59, 60, 72

[33] Sicard, C. (2006), p.1, cp. as well Cavazos, R. (2004), p.1

[34] Sicard, C. (2006), p.1, cp. as well Cavazos, R. (2004), p.1

[35] Cp. in the following Freeman, P.K. et al. (2003a), p.43; Freeman, P.K. et al. (2003b), p.13

[36] N.p. CGAP Focus Note No.30 (2005), p.1, Cavazos, R. (2004), p.1

[37] Cp. Homaifar, G.A. (2004), p.39

[38] C.p. Cavazos, R. (2004), p.2 [90 depreciations, 20 appreciations and 10 times no change of the domestic currency’s value]

[39] Crabb, P.R. (2004), pp.53-54

[40] For the calculation and the respective data please see APPENDIX I

[41] Cp. Bruett, T. (2005), p.4, Goldfine, R. (2005), p.24

[42] Cp. Holden, P., Holden, S. (2004), p.7

[43] Cp. in the following N.p. SwissRe (2003), p.6

[44] Cp. Stockman, A.C. (n.d.), p.119, Olsson, C. (2002), p.226

[45] Cp. N.p. SwissRe (2003), p.5,

[46] Cavazos, R. (2004), p.19; cp. in the following Cavazos, R. (2004), pp.19-23

[47] Cp. Reinhart, C.M. et al. (2003), pp. 18 and 19

[48] In contrast to the „probable maximum loss“, the „possible maximum loss“ includes possible, but not yet experienced events.

[49] N.p., micro capital institute (2005), p.2

[50] Cp. N.p., micro capital institute (2005), p.3

[51] Cp. N.p., CGAP Focus Note No.31 (2006), p.1

[52] Freeman, P.K. et al. (2003a), p.1

[53] Pantoja, E. (2002), p.52

[54] Cp. Freeman, P.K. et al. (2003a), p.1, Freeman, P.K. et al. (2003b), p.17

[55] Cp. N.p., micro capital institute (2005), p.3

Excerpt out of 89 pages

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Title
Foreign Exchange and Disaster Risk Management in Microfinance Institutions
College
Wiesbaden University of Applied Sciences
Course
International Finance
Grade
1,00
Author
Year
2008
Pages
89
Catalog Number
V115636
ISBN (eBook)
9783640220243
ISBN (Book)
9783640222582
File size
1765 KB
Language
English
Tags
Foreign, Exchange, Disaster, Risk, Management, Microfinance, Institutions, International, Finance
Quote paper
Diplom-Betriebswirt Jan-Hendrik Boerse (Author), 2008, Foreign Exchange and Disaster Risk Management in Microfinance Institutions, Munich, GRIN Verlag, https://www.grin.com/document/115636

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