Emerging markets have had a rough couple of months. Among the hardest hit were South Africa and Argentina, which have seen double-digit drops in their currencies. And while they don’t make the headlines, smaller developing countries were also battered. In Africa, for example, the Ghanaian cedi and Zambia kwacha fell by more 10 percent in the last two months.
This volatility hits not only global companies and investors, but also small entrepreneurs who rely on capital provided by microfinance and socially conscious impact investments.
Microfinance lends to small entrepreneurs, such as a group of women starting a textile business or farmers expanding a small dairy-processing facility. These investments – often as small as $500 – have been a vital source of credit in poor countries that lack established banking systems. Other impact investors target sustainable agriculture, alternative energy, health, responsible forestry, and water and sanitation projects.
These funders lend in “hard” currency to institutions in developing countries that operate in local currency in their local market. This creates a mismatch between the dollars or euros the institutions borrow and what they earn locally. If the local currency depreciates, it can leave the institution unable to repay its hard-currency loan. This currency mismatch has been a problem for microfinance from the beginning.
Although microfinance has been around for decades, it began to flourish around 2000, helped by strong economic growth in developing countries and a gradual weakening in the US dollar, which helped bolster local currencies.
Many lenders built up mismatch risk during this period without understanding the potential consequences. Worse, in some instances, the lenders passed this risk to their micro-customers in the form of dollar or euro-indexed loans, forcing small businesses to bear the currency risk.
But this golden age of microfinance came to an abrupt end in 2008 when the financial crisis struck. Many microfinance institutions were hit hard as they saw their effective borrowing costs rise from single digits to 30-40 percent overnight.
Growth slowed temporarily, but the appeal of microfinance both for poor borrowers and large, socially responsible investors did not. As markets moderated, growth returned and total foreign lending to microfinance has roughly doubled from $10 billion in 2008 to $20 billion today.
Equally important, as microfinance has recovered, it has begun to protect itself against wild currency swings by using derivatives, the tools of Wall Street investors. Thanks to the emergence of our company, MFX Solutions, and a handful of others, microfinance institutions can and do hedge their currency risk much more easily and consistently than before the financial crisis.
Hedging currencies means that microfinance institutions can miss out on some gains when emerging markets are stable. But when emerging market currencies are reeling, as they are now, microfinance and impact investors are in a much better position to preserve their profits.
Hedging has also made more lending possible to the very poorest countries in Africa, which typically have the most volatile currencies. Historically, Africa has received less than 8 percent of microfinance lending, but on MFX's microfinance hedging platform over 30 percent of hedged loans are to Africa.
Unfortunately, much work remains to be done. Investors report that they still intend to offer 40 percent of their loans in hard currency, which leaves the risk burden on vulnerable borrowers in poor developing countries. For the world’s poor, who, unlike Wall Street, never have the option of a government bailout, it is critical that efforts to moderate the effects of future crises succeed.
– Brian Cox is president of MFX Solutions, a currency risk-management firm in Washington, D.C., that since 2010 has hedged more than $500 million for microfinance institutions.