Microfinance, Financial Crises, and Fluctuations in Food and Fuel Prices

Date: March 2011 Author(s): Adrian Gonzalez Risk is at the heart of financial intermediation, and microfinance is no exception. Since 2008, considerable attention has been focused on the effects of the financial crisis on microfinance institutions (MFIs). However, most discussions on the financial crisis have paid limited attention to the range of possible risks that are associated with financial crises: liquidity crunches, high inflation and devaluation episodes, economic recession, financial panics, and deterioration of repayment culture, etc. Many of the recent problems observed in microfinance were triggered by the latest financial crisis and fluctuations in food and fuel prices. Still, not all recent troubles were caused by financial crises, as many problems started before the most recent financial crisis, or were intensified by other elements including saturated microfinance markets, deficient systems and governance structures, and negative policy interventions. The Microcredit Summit Campaign recently invited MIX to contribute a paper on Lessons for Microfinance Institutions from Financial Cries, Fluctuations in Food and Fuel Prices, and Other Major Risks, for their Global Microcredit Summit (MCS) in Valladolid, Spain. This article is based on the first two sections of the first draft of the MCS article. Its main goal is to identify the relevant components of financial crises and their potential effects on MFIs, borrowers, and funders. This identification will prove useful in the following analysis in order to develop practical lessons for MFIs. Financial Crises: A Complex and Dangerous Concoction of Risks Most recently, the term financial crisis has been used broadly to reference a range of different international macroeconomic events that were either triggered by the mortgage crisis in the United States, or that coincide with it. However, such financial crises had different effects for developed and developing countries depending on the level of integration of each domestic economy to the global financial system. Liquidity and Credit Crunches In general, liquidity and credit crunches are defined as contractions of the availability of funding. Their main symptoms are a decrease in international investment flows combined with decreases in domestic funding. Which effect is more relevant for MFIs depends on the particular market under consideration and the different sources of funding: domestic, foreign, or savings. For instance, most Indian MFIs are funded by local sources, while in Nicaragua over 80 percent of 20 MFIs reporting are funded by foreign sources. Liquidity crunches are relevant for MFIs because:

Less funding is available for all financial institutions, including MFIs. In particular, for MFIs it is more difficult to attract funding as capital streams dryup due to lack of confidence in the repayment capacity of counterparts. This is also happening for [microfinance] funders that get their funding from sources such as pension funds, banks and individuals, which are directly affected by the crisis. (Wellen and Mulder, 2008) 2. The cost of funds increases, as perceptions of risk change and funding becomes increasingly scarce. 3. Funders prefer shorter term transactions because they might be afraid that they are not able to refund their own funding and because they are less sure that they will get their outstanding credits back (Wellen and Mulder, 2008). A preliminary analysis of MIX Funding data suggests that for a sub-sample of countries with more than 10 observations per year, the average maturity of total debt in the 2007-2009 period was 46 months. The average for foreign sources was 54 months (59 for foreign currency loans) versus 43 months for local sources (45 for local currency loans). However, additional analysis is necessary to identify changes in the average terms for stable samples of MFIs in different markets. 4. Funders prefer debt in hard currency, as they become more risk averse and shift foreign exchange risk (FX) to borrowers. Foreign exchange risk arises when fluctuations in the relative values of currencies affect the competitive position or financial viability of an organization (Featherston, et.al. 2006). For MFIs, this risk arises when there is a mismatch in the currencies in which they borrow and lend. If an MFI borrows in foreign currency and lends in local currency, they can suffer substantial losses if the value of the domestic currency depreciates in relation to the foreign currency, meaning that the MFIs assets drop relative to its liabilities (CGAP, 2006). In addition to the devaluation or depreciation risk, MFIs are exposed to convertibility risk (foreign currency is not available for sale) and transfer or remittance risk (transferring hard currency outside the country is not allowed).
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High Inflation Episodes High inflation episodes are a common risk for MFIs, especially those operating in countries with weak monetary policies, or unsustainable economic regimes. In the case of MFIs, inflationary episodes are relevant due to the following: 1. Salaries increase due to inflationary spirals: as prices increase, labor markets adjust and salaries go up. In addition, the prices of other inputs may increase as well affecting both personal and administrative expenses. 2. Changes in the relative prices of goods and services bought (inputs and consumption) and sold (produced) by MFIs borrowers. This could be caused by different markets adjusting at different speeds, resulting in some goods or services being more expensive than before, relative to other goods and services. 3. Changes in food and fuel prices can feed back into the inflationary spirals that triggered them in the first place.

Currency Devaluations Currency devaluations can happen on their own or can be accompanied by inflationary episodes. Devaluations imply significant changes in exchange rates with serious consequences for the asset liability management of MFIs, and thus MFIs should prepare for these episodes as well. Global Recession Global recession is another catch-all term used to reference the multiple events. The most relevant of these events for MFIs include: 1. Higher unemployment and lower domestic demand for goods and services produced by borrowers 2. Lower remittances, because of global recession 3. Deposits and savings withdrawn by savers to weather recession and income reductions 4. Reduced demand for loans for productive activities vis-a-vis increased demand for loans for consumption-smoothing purposes Financial runs / panics, loss of trust in financial systems Runs on financial services providers can affect MFIs directly and indirectly: 1. Indirectly, through the failure of non-microfinance financial institutions. This is especially troublesome if MFIs have any business relationship with them, including: Concentration of assets including savings and cash Debt or other liabilities Cash management

1. Directly, through financial runs by customers of MFIs. During a financial panic, MFIs may experience both heavy withdrawals of deposits, and deterioration in portfolio quality as borrowers doubt the future sustainability of MFIs. Food and Fuel Price Crises Increasing food and fuel prices, without comparable increases in income, force borrowers to allocate higher proportions of income to those expenses and directly affects their ability to repay microloans (USAID, 2009). In addition, borrowers may reduce food consumption, migrate in search of cheaper food alternatives, sell productive assets, withdraw savings, or reduce their willingness to save in order to buy food (Duflos and Gahwiler, 2008). In addition, strong changes in food and fuel prices can trigger or increase inflationary crises. One notable difference between food crises

and the other risks previously discussed is that food crises directly compromise the survival of many clients, and MFIs may feel compelled to engage in additional activities in order to mitigate their effects. Potential Effects on MFIs As previously discussed, financial crises usually involve multiple events with serious consequences for microfinance. However, some of these events affect MFIs directly (like inflation and devaluation), while others affect MFIs indirectly through their impact on funders, borrowers, and the rest of the financial system. The goal of this section is to summarize the most important consequences of financial crises from the MFI perspective, relating them back to the previous discussion of components and subcomponents of financial crises. All results are summarized in the following table. If we read this table along the rows on the left, we can see the main components of financial crises and the symptoms that are relevant for MFIs. If we read this through the columns along the top, we can see which of those components impact different factors for MFIs. Table 1: Financial Crises Components and Effects on MFIs
Impact on Financial Crises Symptoms Components Less Funding Available Funding More Expensive Liquidity Crunch Longer Term Funding Less Available Local Currency Funding More Scarce Inflation, Food Salaries may go up and Fuel Crises Prices of food/fuel may increase Devaluation Increase FX Deposit Growth Mobilization Supply Side Financial Financial Financial X Supply Side Operating Financial Financial Financial Financial Financial Financial Financial X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X Expenses Interest Rates Asset ProfitaRepayment Liability bility Mgmt

Lower Demand for Goods and X Services Produced by Borrowers Economic Recession Savings Withdrawals Remittances Repayment Culture Financial Panics X X X X

Demand Side Supply Side Supply Side Supply Side Supply Side

Whats next? As part of research team on risk, we are planning to explore the following topics: 1. Reassessment of the resilience of microfinance during the last financial crisis, reevaluating if portfolio quality has become more correlated with local macroeconomic shocks.

2. Exploring the relationship between policies and process during periods of accelerated growth and high penetration markets 3. Lessons and policy recommendations for MFIs based on this research