THE IMPACT OF FOREIGN EXCHANGE RISK IN MICROFINANCE BANKS
A Focus on Liberia
The research paper focuses on the impact of the foreign exchange risk on the microfinance banks. The focus is on Liberia, and the use of Access Bank of Liberia to get an insight on the state of microfinance sector in Liberia. Foreign exchange risk is a complex entity that requires an understanding of both the internal and external systems of the banks. As expected, the banking sector in Liberia, and globally, faces unprecedented challenge sin this digital age of hacks, cybercrime and increasing competition due to emerging innovations. The banking sector in Liberia is characterized by problems such as dependence on donor funds, underdeveloped fiscal policy, inadequate infrastructure and a disjointed economy that all have a bearing on the fiscal strength. The Access Bank of Liberia remains one of the oldest microfinance institutions and has been operational in the country for decades, and Montserrado County has been one of the areas it has been largely operation. The bank is used as an example on how other microfinance banks in the country are operating. The main objective of the research paper is to evaluate the impact of foreign exchange risk in the microfinance sector.
The paper utilizes a descriptive and an inferential methods of data collection. The suitability of these two methods is because of their ability to let a researcher make observations and a detailed analysis of the data collected. The consensus approach is also used to pick out all the banks used for the research process. The paper collects secondary data from the audited reports of microfinance banks in Liberia. The multiple linear regression was used to compare the relationship between the independent and dependent variables.
The findings show that the foreign exchange risk is manifest in Liberian banks. The findings collaborate the need to put in place measures to cushion microfinance banks against foreign exchange risk, including methods such as forward contracts and hedging. There were some limitations in the study such as a small number of sample size. The research hopes to further improve knowledge on the foreign exchange risk and offer policy recommendations to Liberian banking sector.
Table 4.1 Descriptive Statistics ………………………………………………….38
Table 4.2 Correlation Table ………………………………………………………39
Table 4.3 Analysis of Variance …………………………………………………..39
Table 4.4 Regression model ………………………………………………………40
Table 4.5 Multicollinearity ……………………………………………………….41
Foreign exchange risk is a critical segment of any bank’s decision based on risks due to foreign currency exposure. Research by Wright, 2019 indicates that the microfinance sector experienced rapid growth from 2006-2010. In seeking to validate this paradigm, it was explained that “this development was mainly enabled by the sector’s ongoing interaction with international capital markets, which made microfinance institutions (MFIs) more and more independent from donations” (p.41) according to Yunis, 2017, and this led to most microfinance institutions, banks included, to embrace professionalism and focus on profit-making.
The currency risk strategies require an understanding on how to eliminate these risks, coupled with an insight on how the exchange rate risk affects both the economic performance, and modalities of dealing with any arising complications. Times have shown that coming up with the appropriate hedging strategies remains an intricate process due to the complexities of projecting an accurate and relevant estimate, based on the prevailing economic conditions. There are some factors such as pandemics, political environments, global economic outlook, and adverse weather conditions, among others that have a far-reaching impact on foreign exchange rates, and cannot be accurately anticipated nor projected (Temitope, 2017). The disintegration of the Bretton Woods system and the subsequent end of pegging the US dollar to gold in 1973 signaled the need to have a currency risk management structure.
An emerging trend as shown by (Berenbach and ChurchilL, 2016) that microfinance institutions, including banks, have regressed to accepting loans from foreign institutions and entities. It reflects the continued integration of the global capital structures. However, this means that microfinance institutions have to find ways to mitigate the impacts of the foreign exchange risks. The problem is that most MFIs and banks have not entrenched systems that can adequately deal with the foreign exchange risks (Sengupta and Aubuchon, 2018). There is a disproportionality of the foreign exchange rates that shows that banks in developing countries, with underdeveloped financial systems and the established financial mechanisms that have been recommended in managing foreign exchange risks are almost inapplicable. It means that the final decision on how to deal with the foreign exchange risk rests with the micro financial banks or the foreign investors.
Ironically, the continued rapid growth of the micro financial institutions and banks has only elevated the importance of the foreign exchange risks to astronomical levels. In a synchronized and highly interdependent world, micro finance banks have become an important tool to fight shared problems such as poverty reduction, infrastructural development amongst others. The International Financial Institutions (IFI) have been at the heart of these transactions, and this means that banks rarely suffer from a shortage of capital through local banks, donors or even the foreign fund sources (Vanek et al., 2014). On the flip side, such funding means that there should be a prudent management of the foreign exchange risks. Coupling the problem further, the financial underdevelopment in most developing countries means that there is a variation of domestic liquidity, and in some instances, excessively expensive. As the micro finance banks grow and the financial interdependence becomes a norm, there is a need to ensure that there is a clear structure to deal with the foreign exchange risks. This paper seeks to extrapolate on the foreign exchange risks in the current world, and to show some of the tools that can be used to help mitigate the associated risks. Micro finance banks are at the heart of financial systems globally and they should have multiple tools to deal with the foreign exchange risks. Furthermore, the paper seeks to highlight on some of the reforms that should be undertaken in the financial sector to make it more inclusive, especially for the developing countries.
Foreign exchange risk is defined, in basic terms, as “the risk related with the unexpected changes in exchange rates and foreign exchange exposure as the extent to which unexpected changes in exchange rates affect the value of a firm’s assets or liabilities” (Menkhoff et al., 2015, p.689). It has been further affirmed that in the international trade structure, firms have to contend with the payables and receipts, highlighting the imperative nature of foreign exchange. At the end of the day, there is a consensus that the foreign exchange risks should ensure that they generate economic value to all parties in the trade environment (Oshota and Badejo, 2015). Some economists have argued that foreign exchange should be interpreted as a value creation and loss prevention paradigm, enabled by both the internal and external factors. The small firms, however, can depend on the instability of the foreign currencies to make profits, through aspects such as inflation management.
The foreign exchange risk arises if the competitive position and viability of an organization is affected by the fluctuation of the value of the relative currencies. The exposure to foreign exchange risk is caused by a vulnerability to any future exchange rates, coupled with an inability to predict and certainly determine the impact of any disruptions. There are three different types of exposure.
- Transaction risk: It arises when the existing obligations become worse because of the changes in the foreign exchange rates. It can be used by the bidding trade contracts that depend on foreign currencies (Khavul, 2016).
- Economic Exposure: Caused by a sharp and unanticipated change in the foreign exchange rates, that affects both the foreign and domestic operations of a business entity.
- Translational Exposure: It is caused by a currency mismatch, and usually relates to incomes from offshore activities.
In short, the foreign exchange risk arises when there is a disparity of the assets held by a bank compared to the loan obligations that fund the bank’s balance sheet. For instance, if a local currency sharply depreciates compared to the USD; it translates to an increase in debt servicing compared to the revenues available. In extreme cases, micro finance banks have been affected by this disparity, and inability to meet their loan obligations leads to negative rating, further curtailing their ability to raise additional funds. The MFIs are specifically vulnerable because of their popularity in developing countries, where such shocks are common.
The number of MFIs has been on an upward trajectory, and research shows that successful MFIs can outgrow the need to keep injecting foreign capital. The idea that needs to be pushed is that MFIs need to explore ways to raise additional capital rather than heavy reliance on donor funding. In a study conducted by Hasan, 2015, he found that commercializing MFIs and holding them to the same rules as commercial banks not only increases their operational structure but also their long-term viability and making them effective intermediaries. However, while successful micro finance banks have shed the need for donor funding, developing structures and capacity to raise capital locally remains an uphill task. The domestic capital in most developing countries is characterized by severe underdevelopment and a predominance by the commercial banks in lending. Also, there lacks a second tier of the financial sector. Consequently, it means that MFIs have limited options to raise capital, which are expensive in the long-term. The lack of competition and openness among the commercial banks compounds the problems further. It has been summed up that “domestic funding is short term, callable with short notice, an d the markets cannot effectively issue long term financing” (Dorley, 2014, p.48) say, secured bonds. In some developing where securitization of bonds is available, the legal framework has been found to be inadequate. The domestic banks that have monopoly of lending funds tend to be reluctant in dealing with new entrants in the micro financing sector. It implies that any new MFIs make their entries with a solid financial footing. In the long run, it limits competition among the MFIs, leading to an underdevelopment of the sector. The situation does not become any better, especially when one considers that the IFIs have formed a tendency to deal with the established MFIs and their reliance on foreign donors to boost their credit worthiness (Bystroem, 2018). The difficulties in the liquidity in most developing countries implies that the need for foreign investors will continue to rise, until a time when such countries will have a vibrant and stable financial structure. The problem is that financial reforms is a long term process that often takes decades.
With this in mind, it means that MFIs will be a major constituent in dealing with foreign exchange risk both in the short and medium term. This further shows why the foreign exchange risks needs a multi-faceted approach, rather than the current framework in which the risks are mainly passed to the receiving parties, usually the MFIs.
Foreign exchange involves trading one currency for another. Under normal circumstances, foreign exchange can take place in the spot market- usually in two business days, or under contractual obligations which should be met in future.
Both parties involved in a foreign exchange transaction, either as assets or liabilities, do so with an assurance of risks for each of them (Holden and Holden, 2014). Some of the risks include exchange rate risk, economic risk and even a country’s risk.
However, there are some options that those vulnerable to foreign exchange risk can undertake. First, they can do nothing, which means that they can absorb the shocks, and the foreign exchange risks, depending on the movement of the foreign exchange rates. Notably, letting the markets break even on their own is the most recommended actions, especially when the depreciation or appreciation of either of the currencies involved is minor. In cases where the exchange rates movement is significant, like it happened in Argentina 2002-2003, or in Mexico in 1994, doing nothing is not tenable (Khoury and Chant, 2018). Secondly, hedging can be used, which means that one covers the risk on future foreign currency obligations. Lastly, the last option is mixing, which requires one to use the time between recognition of the risk and the time for the obligation, and determining the lowest possible value of the foreign currency for the intervening period (lossifidis, 2020). Hedging serves as an insurance against any adverse changes in the foreign exchange rates. The main aspect of hedging ensures that a foreign currency borrower benefits when their local currency appreciates, but eliminates the risks and economic loss when the opposite happens. For the lender, the reverse holds as true. Hedging is not a cheap process, and MFIs have to evaluate the risks that they are exposed, and the hedging options available. The micro finance banks operational in developing countries, especially in Latin America and Africa, have both limited funds and hedging options.
In an attempt to manage the finance exchange rates, some of the MFIs have formed internal hedging mechanisms that offer loans in local currency, though this mainly happens in countries that have a robust financial system. During the last economic recession, experience in 2008, some of the MFIs that had been denominated in foreign currencies suffered huge exchange rate risks, leading to collapse. The idea, pushed by Mwakajumilo, 2016, is that when it comes to an analysis and understanding of the micro finance sector, contextualization of the country, and the prevailing economic condition.
The paper will focus on Liberia’s micro finance sector and how it is affected by the foreign exchange risks.
In most of the least developed countries, under which Liberia falls, the banking sector tends to serve less than 20% of the total population (outlook, 2019). It means that the majority of the population, typically characterized by low incomes and meagre savings, do not have access to formal financial services. Microfinance banks have emerged as a way of trying to bring such excluded populations into the financial sector. It has been further observed that “providing microfinance services, primarily micro credit, is seen as a method to generate self-employment opportunities for the poor who are excluded from obtaining loans from conventional financial institutions” (Oya, 2016, p.39). The World Bank has set a standard of $1.25 a day as a threshold for poverty line, and based on this figure, at least 25% of the total world population lives below the poverty line. In absolute terms, this represents up to 1.3 billion people globally. However, there is a disproportional representation of African and Latin American countries in this segment. The United Nations, through the United Nations Millennium Development Goals, there were concerted efforts to halve the global poverty levels, which was not achieved. The microfinance banks have become an integral part of such concerted efforts to alleviate poverty.
Liberia is a reflection of the traits that have been identified above. In a global scale, the country remains one of the poorest countries in sub-Saharan Africa. Additionally, the country is enjoying relative peace following a protracted internal conflict. Interestingly, a historical analysis of the country shows that it is the extreme poverty levels that degenerated to civil strife. A majority of the population are engaged in subsistence farming and small retail businesses, and this limits their ability to access credit from financial banks. Based on this understanding, it means that these citizens have to find alternative ways of credit, and microfinance banks act as an alternative source of funding.
The Liberian government has joined hands with the United Nations Development Program (UNDP) and launched the Poverty Reduction Strategy (PRS) formed the Microfinance Department at the country’s central bank. The main aim of this initiative was to provide the large population that is locked out of the financial department with credit services, protect the interests of the deposits made to the microfinance banks and a need to strengthen the financial sector, to avoid any strain that can lead to total collapse of such systems (Prowd, 2020). Liberia was one of the most prosperous countries in sub-Saharan Africa in the 1960s, but this was affected by the conflict that ensued in subsequent years. It is ranked as the last twenty poorest countries in the world, and this further retaliates the important role that the microfinance sector plays in the country (Outlook, 2019). The Core Welfare Indicators Questionnaire released its rankings that show that more than half of Liberians, approximately 56% live below the poverty line.
Encouragingly, there has been a steady reduction of the number of people living below the poverty line levels, and this is a good sign, especially for a country emerging from a devastating civil war. The main challenge is that while these statistics are on the rise; it has not translated to a significant improvement in the living standards among the people. The Human Development Index (HDI) of Liberia is estimated at 0.276 out of a possible 1.000, which shows the significant work of microfinance banks in the country (Tyson, 2017). While the paper will seek to explore the impact of the foreign exchange risk and how it affects the overall mandate of microfinance banks in Liberia, and their efficiency in carrying out their roles, especially in poverty alleviation and expansion of financial services to individuals who are otherwise locked from the formal financial sector.
The Access Bank of Liberia will serve as a main source of data because of its heritage of being at the forefront of seeking to improve the social and economic populations in Liberia. The research will also focus on some of the client’s perspectives on the impact of the microfinance banks, and how they have been affected by perceived shocks in the monetary sector. It should also be noted that the Access Bank of Liberia remains the only microfinance entity in the country that allows deposits from its clients, and serves Montserrado County, the oldest and most populated county. The county also hosts the capital Monrovia, which has attracted 70% of the total population, mainly because of the urban services available in the capital; coupled with the political sphere (Dorley, 2014). The bank is backed by both local and international lenders, having been established by the African Development Bank (AfDB), International Financial Corporation (IFC), European Investment Bank and Access Microfinance Holding, which shows that the bank is not immune to the foreign exchange theory risks, especially because of the weakness of the local currency and a reliance on foreign exchange.
Additionally, the paper will seek to have a comparative view on Liberia and other countries in sub-Saharan Africa and Latin America, and to have an understanding on how the microfinance banks in Liberia are affected by the foreign exchange risks, and the steps that should be undertaken into the future. Liberia has enjoyed stability over the last decade but due to time and financial constraints, the research could not have incorporated all the microfinance banks in the country. Additionally, because of the complexity of the modern world that has made it difficult to access sensitive information such as the financial records and transactions, there could be some gaps when it comes to areas that seek to have a valid structure of the financial data. However, the data collected from Access Bank of Liberia represents an accurate view on the microfinance banks in the country.
A firm’s debt ratio is defined as its debt obligations compared to the total equity in the company’s capital structure. When one looks at the microfinance banks, the financial performance is a key indicator of a bank’s long term solvency and the financial risks that the company faces. Why? The foreign exchange rates are vital in completing transactions both in the import and export structures. Moreover, the foreign exchange can affect the financial performance as it can affect factors such as the inflation rates and the overall microeconomic conditions in the world. The exchange rate risk has also affected the Liberian economy; considering that it is an importing country with minimal exports to contribute to the foreign exchange rates. It has been further remarked that “as least-developed country, Liberia’s economy continues to experience depreciation of its local currency in the foreign exchange market for the past years. This alarming depreciation of local currency makes foreign commodities more expensive and has the propensities to affect capital account and subsequently result to deteriorating terms of trade (ToT)” (Dowla, 2016, p.116). The paper further focuses on the foreign exchange and real exchange rate on the Liberian trade, and its overall economy.
The volatility of the foreign exchange rate risk can either lead to a negative or positive difference in the volume of trade. Microfinance banks serve the people who are most vulnerable to any changes, however insignificant, to the foreign exchange rates. For instance, when one looks at the Access Bank of Liberia, most of its clients come from the low and middle income class, which is almost 90% of the total population. The implication is that the foreign exchange risks can either lead to a competitive advantage in terms of trade, or can lead to the people being affected negatively.
Trade has the capacity to alter the distribution of resources among broad groups of people, such as the workers and investors. This is common in ‘specific’ industries that have to compete with foreign companies and industries, which means that they have little room to absorb any shocks in the financial sector. The essence of foreign exchange is that it allows people from different countries to compare the pricing of goods and services globally, and then make purchases (Hubka and Zaidi, 2015). The abandonment of the fixed exchange rate means that the volatility of the rate has been more present than ever, and has been alarmingly relevant in a globalized world. Perhaps, it is not surprising that most economists have been aloof to address the impact of the exchange rates to the foreign trade volumes. The idea is that the foreign exchange risk affects the wages, economy, prices, interest rates and productivity levels, which includes job creation and market expansion. Over the last decades, there has been a significant increase in the liberalization of the capital flows and cross-border trade among nations, and this has further pushed the foreign exchange risk to uncertainty. Microfinance banks, not just in Liberia but globally, have to find a common path on how to shield themselves and other sectors of the economy, both local and international, from the effect of the foreign exchange risk (Agarwal, 2017).
The volatility of the foreign exchange risk affects the stability of international trade. The use of markets-based approach, common in Eastern Europe and Asia has further created a new platform for adjustment of the currencies involved in such trade. Studies carried out by Best, 2020 from 2004-2014 showed that the foreign exchange rate has a negative effect on trade volumes, especially on exports. Subsequently, these studies established that there is a correlational existence between the trade volumes and the foreign exchange rate, both in the short term and in the long term. Interestingly, and rightly so, the impact of such paradigms depends on the movement of the currencies, and the financial risks of such movement. Doganlar and Ozmen, 2015, carried out a study on the impact of exchange volatility across five nations (South Korea, Turkey, Malaysia, Indonesia and Pakistan), he came to the conclusion that the foreign exchange risk affected real exports to these countries. It implies that producers in these countries are risk-averse and prefer to sell internally rather than export, as a way of dealing with the exchange risks. It also means that with a risk-averse aspect, there is a reduction in the marginal export utility, and this ultimately leads to a reduction in the exports of a country. If there is extreme caution, the foreign exchange risk can inhibit the trade flows as companies will be unwilling to engage in export business, and thus overlooking the opportunities that come with an integrated business environment.
Over the last few years, the foreign exchange risk has been felt across the emerging economies and the least developed countries such as Liberia. Under normal circumstances, factors such as distance and quality of products in foreign trade, aspects such as the fiscal policy and import quotas also play an integral role. In an argument pushed by Blanpain and Bisom-Rapp 2016, the use of tariffs as a way of controlling international trade is ineffective in least developed countries such as Liberia because of the huge dependence on imported goods. Additional research by Cull et al., 2019 showed that the absence of trade tariffs in some East Asian countries has affected regional trade, specifically because of the exchange volatility risks. It has been proven that the depreciation of a country’s currency affects its trade balance greatly, but such impact varies depending on the economic development of a country. The Marshall-Lerner condition, which proposes “real depreciation leads to increases in the trade balance in the long run if sum up value of import and export demand elasticity exceed one” (Mcguire and Conroy, 2018) and this has been amplified in the Liberian fiscal structure.
In the microfinance sector, the gross profitability acts as the true measure of economic progress, if any. One of the most intriguing aspects of profitability is the need to have a context on the interactions between different factors, and how they all culminate into incomes. For instance, a firm that has low production costs and higher sales, is definitely going to have high profitability. However, competitors of such a firm can easily have higher revenues. The idea being propagated is that, while the microfinance banks may enjoy some form of stability due to the high numbers that they serve, in most cases, they tend to have a lower financial power compared to the commercial banks. There is also the Return on Assets Ratio (RAO) measures the efficiency of managing its assets and generating profits. ROA is also known as the return on investment.
ROA = Net Income/ Total Assets
When preparing a financial statement (MIX) definition, the RoA is calculated as: Net Operating Income Taxes/ Average Assets. The higher the percentage, the better the company does in utilizing its assets to generate sales.
There has been a growing academic view that purports that foreign exchange risk affects the financial performance of not only microfinance banks but also the overall economy (Siagplay et al., 2016). There have been diverging views on the validity of this position, though this has been attributed to a differentiation of the theoretical perspectives applicable, research methodologies, and conflicting views among economists and a variation in performance indicators coupled with economical differences. The common position is that there seems to be inconclusive results that accurately show foreign exchange risk affects the financial performance of microfinance banks and firms. The main issue is that the previous studies have been inconclusive in showing currency risk affects the financial performance of both the commercial banks, and the economy in general. In the modern world structure, the corporate structure integrates risk management departments, and any vulnerability is mainly blamed on poor management, rather than the prevailing fiscal policy. Therefore, better risk management is seen as a corporate strength, and a trait that should be embraced.
When it comes to foreign exchange, the use of risk management leads to minimization of the risks, and compensation of any risks. According to Strauch and Strauch, 2019, any changes in the foreign exchange rate affects the cash flow, both in the short and long term, and ultimately, the stock prices. There have been further arguments by Hartmann, 2014, which indicate that the exchange risk can be managed through operational and financial hedges, as a way of managing cash flows and structuring of the foreign currency. In a study carried out at the Johannesburg Stock Exchange on 14 firms by International Monetary Fund, 2018 found that better foreign exchange risk management is associated with better performance, using the Tobin’s q and ROA.
Liberia has a dual currency policy; which means that both the USD and the Liberian Dollar are held as legally binding. The country has a very weak fiscal policy, and uses a float exchange rate whereby there are no predetermined paths of the foreign exchange rate, and in case of any major fluctuations in the exchange rate, the Central Bank of Liberia (CBL) springs into action with a goal of maintaining price stability. The monetary policy that all microfinance banks have to contend with in Liberia is one that seeks to have a balance, in tandem with the goals of the national treasury. In this case, the stability policy is regularly reviewed as a way of cushioning the liquidity of the Liberian dollar. Over the years under review, there has been a consistency in the economic steps that have been implemented to address the exchange rate risk. Commercial and microfinance banks have been tasked with ensuring that the inflation rate remains low and availing credit to the people. The CBL, on the other hand, helps financial institutions by extending their repayment period and reducing the interest rates. However, while this has been the trend, in recent years, there has been an increased volatility of the USD, and these steps are aimed at maintaining liquidity for the Liberian dollar.
The interaction of the USD and the Liberian dollar has for long been used as the determinant of value of goods and services in the market. The dollarization of the economy has been blamed for the continued depreciation of the local currency (Donou-Adonsou and Slywester, 2017). Economics show that this trend has been backed by inadequacy of the foreign exchange reserves and a high growth of imports. The depreciation is apparent in the current account deficit in Liberia. In Liberia, the effect of the exchange rate is significant because of the surplus local currency, the USD becomes the most accurate tool through which the value of domestic products is determined and transmitted. Therefore, the exchange risk is more pronounced as it disorients the inflation rates, and the pricing of goods and services.
The foreign exchange risk is a complex problem that requires an in-depth understanding of the dynamics of an economy, including the financial movements at a global scale. For microfinance banks, one needs to develop a background on the business needs, target market, internal and external environment and interactions with the financial markets. Additionally, the microfinance banks have a specific purpose, vision and values, which means that any actions they undertake should reflect the impact they seek to make. In Liberia, microfinance banks have to be a consideration of the business environment, history and capacity of the clients and risk exposure. In simple terms, the complexity of the exchange risk for microfinance banks not just in Liberia but rather globally, is heterogeneous. One cannot say that there is a ‘one size fits all’ when it comes to the impact of the exchange rate on microfinance and commercial banks (David and Mosley, 2017). It is the efforts by the banking sector to deal with the exchange rate risks that has been at the heart of further spreading the problem. In Liberia, majority of the population does not have access to formal banking, which has further increased popularity for the microfinance sector. While it is commendable that the microfinance banks are trying to liberate and assimilate these people to the dynamics of the modern world, the wide clientele means any collapse or mismanagement of the sector would have far-reaching economic shock, and to millions.
The microfinance banks in Liberia contend with a myriad of problems. First, there is the underdevelopment of the fiscal environment, an informal banking sector and a population that requires tinkering of the conventional banking laws. The inclination is that microfinance banks cannot purport to operate the same as the commercial banks, irrespective of any noble intentions. In Liberia, an estimated 70% of all transactions are carried out with foreign currencies, increasing the microfinance’s banks to exchange risk (International Monetary Fund, 2018). The last economic recession of 2008, on top of the civic instability in the country, the banking sector faced heavy foreign exchange losses, and this led to a near collapse of these banks. In emerging economies such as Liberia’s, the standard tools that are used to minimize the risk of exchange risk such as options contracts and swaps are either not readily available or too expensive. If available, the inefficiency and imperfect nature of the markets makes it limiting to rely on such products. It means that the microfinance banks have extra pressure to find a viable way through which they can protect themselves from the exchange risk (Clower, 2016).
The Liberian economy has not been spared by the usual political rhetoric, and this has led to undue pressure of the government in seeking to exert control in a market already faced with unpredictability and inefficiencies. For instance, the government has been undertaking poverty reduction strategies, which have focused on investing in basic infrastructure such as housing, primary education and infrastructure. The Access Bank of Liberia, a key microfinance bank, has been making strides to provide credit and deposit services to the poorest of the poor but it feels that the safety and stability required for an evolution of the fiscal policy is not assured in the country. These sentiments reverberate across the entire microfinance sector as politics and economy often clash. The staff and institutional assets ought to be protected by the government, and while this has improved, there seems to be a long way before such security can be guaranteed in Liberia. It has been further remarked that by Bori and Togba, 2017 “a stable economic environment as well as easy access to credit and high economic growth is very essential factors for microfinance in a post conflict nation like Liberia” (7). The microfinance banks can only have the required impact in a country that is able to advance loans to its people who are economically active, and have access to opportunities that enable them meet their credit obligations. There are knowledge gaps on the effect of foreign exchange risk on the economy, but in Liberia, there seems to be a clear correlation.
The research explores whether the main conditions necessary for the thriving of the microfinance banks in Liberia have been met. Additionally, the research paper will also seek to develop an insight on the impact of the exchange risk on the microfinance sector in Liberia, using the Access Bank of Liberia as a case study. The following questions will further inform the discourse of the paper; is there a clear and valid relationship between the exchange rate risk and the microfinance sector in Liberia? Secondly, how do the microfinance banks deal with the foreign exchange risk, if any? Lastly, the paper will also answer the question, how does the foreign exchange risk affect the financial performance of microfinance banks in Liberia?
The objective of the study is to establish the impact of the foreign exchange risk and its management in the microfinance banks in Liberia.
- To establish the existence of the foreign exchange risk to the microfinance banks in Liberia.
- To assess and evaluate the impact of the foreign exchange risk and its management on the financial performance of microfinance banks in Liberia.
- To show how microfinance banks in Liberia, compares to other emerging economies, and how best to deal with the foreign exchange risk.
- To offer solutions on how microfinance banks in Liberia, and beyond, can deal with the impact of the foreign exchange risk.
This study will act as a future reference to the Liberian population, especially the Central Bank of Liberia on how it can deal with the shocks of the foreign exchange risks. Moreover, the study can add its voice to the growing number of economists who have shown the impact of an imbalanced field of play in international play, and how variation in the value of currencies affects emerging economies. This has been an area that has generated a lot of skepticism and this study can offer its insight on some of the matters that can be used to further the scholarly deliberations. The literature, study analysis and findings coupled with the recommendations will be an additional to the existing knowledge on exchange rate risks.
The microfinance banks in Liberia and developing economies are the main tools driving economic change through poverty reduction programs. The inability of the formal banking sector to bring all segments of population to the sector means that the microfinance department has been left to serve majority of the population. Some findings in the study will be utilized by national treasury, international bodies and investors in trying to make sense on some of the key areas that they can highlight to create more impact in the Liberian economy.
The study will also be used as a standard on how some of the areas in future research can be developed. Knowledge is an unending fountain and this study only brings out some areas that needs further analysis. It implies that the research has partly covered and generated knowledge, but more needs and can be done to further the issues under consideration. The research proposes some key areas that can be used to develop academics in future.
All the terms that have been used in the study have been explained at the very context that they have been used. In most cases, the financial structure tends to have different implications and a generalization of terms, despite their objectivity, there should be a clear view of any terms at the point of use to facilitate understanding and clarity.
The chapter lays the foundation for the research paper. It gives a breakdown on the relevant factors that will guide the research process. There is also a key paradigm of ensuring that the research gives direction of its scope, and specific areas of interest.
This chapter will focus on the evolution of foreign exchange risk, both at a global level, and in Liberia. Additionally, the chapter will also seek to evaluate some of the methods that have been useful in dealing with foreign exchange risk, and analyze their effectiveness. The foreign exchange risk management is a common practice, and it depends on some of the theoretical perspectives pushed by scholars, and in some cases, use of predictive patterns that have been developed by the fiscal policies. The chapter focuses on some of the empirical studies and general literature on microfinance sector, specifically in Liberia, and draw conclusions from the knowledge generated.
According to Crabb, 2014, in most cases, the foreign exchange risk is managed through the internal mechanisms, even in the microfinance sector. However, there have been some studies that have sought to show the invalidity of seeking to use any methodologies in managing the foreign exchange risk. The argument pushed show that the foreign exchange risk even out in one form or another in future. It is vital to start an academic discourse to try and have an understanding on some of the strategies that have been put forward.
This was a theory first developed by Gustav Cassel, a Swedish economist in the 1920s. In seeking to develop the theory, the economist wanted to understand the relationship between currencies of different countries. The gist of the theory is that it sought to develop an insight on how the foreign exchange rate affects the currencies in different countries. The economist argues that “the PPP holds if and when exchange rates move to offset the inflation rate differentials between two countries” and this has been translated to the ‘law of one price’ (Cassel, 2018). The interpretation is that despite the variation of the value of different currencies and the underlying dynamics of the foreign exchange rate, identical goods and services in any two countries should be similar. The PPP asserts that there should be a connection and relativity of similar goods and services, irrespective of the exchange rates. The implication is that under the floating exchange regime, if there is any movement in the PPP, then any changes in the pricing of goods would be calculated through a price ratio of the traded goods compared to the exchange rates, and this should give the accurate paradigm of any differences as argued in Assets, 2015.
Therefore, the PPP argues that if there is a significant change in the price level in a country, this leads to a depreciation of its exchange rate, compared to other countries. As such, this should lead to a stabilization of similar goods and services across these countries (Cassel, 2018). The PPP is adamant that the foreign exchange rate should not have any impact because of the ‘law of one price’ which offsets any impact caused by movement of the exchange rates. The simplification of the law is that in a competitive market, identical goods and services should retail at the same price, when evaluated under a homogeneous currency. It is important to note that PPP focuses on an individual item, and its generalization can either be absolute or relative, depending on the price levels, without affecting the structural relationships between two nations.
Cassel, 2018 argues that some basic assumptions of the PPP is that all goods can be traded, and there are no additional costs such as taxes, transport and tariffs among others that generally have an effect on the price levels globally. Of importance is that PPP assumes that exchange rates are only affected by the inflation rates in each country. It is because of these assumptions and the law of one price that led to adoption of monetary values for exchange rates. Currencies are viewed as assets, subject to equilibrate of the financial assets globally, and the future expectations drive the appreciation or depreciation of any assets. Hence, this theoretical view has long been regarded as the asset approach.
The main idea is that any difference in the interest rates in two countries is evened out by the movement of the foreign exchange rates. The theory submits that:
Interest Rate Differential = Differential Forward Exchange Rate / Differential Spot Exchange Rate
However, it should be noted that the interest parity plays an integral role in determining the foreign exchange rate as it affects the spot and foreign exchange rates. In the context of the paper, according to Arai et al., 2015, they have argued that the economic theory shows that there is a breakdown in efforts to try and show a clear correlation between the interest rates and the exchange rates. If the argument holds, it means that the changes in the exchange rates are no longer subject to the international interest differentials. Donou and Slywester, 2017 have shown that there could be other economic theories, including the purchasing power parity and monetary model that have little if any impact on predicting the trends of the exchange rates. A commonality across these studies is that they all dispute any uncovered interest rates. It is not surprising that Dumas and Solnik argue that there could be other explanation, such as risk aversion and market segmentation to explain the uncovered rates, rather than market inefficiencies. There have been contrasting voices, such as lossifidis, 2020 who has suggested that the forward exchange rates are unbiased predictors for the spot exchange rate that follows, and this should not be a puzzle. This seems to be one of the key areas that literature remains scanty and future research should try to demystify any grey areas.
This is one of the most contemporary theories. In the arguments pushed by Mimouni 2016, there is an opinion expressed that shows the foreign exchange rate should affect multinational companies, specifically in net sales and assets in foreign countries because they use the local currencies of a company. The earliest empirical studies on this area, carried out by Makin, 2018 did not establish any significant fluctuations in the stock prices due to the foreign exchange risks. However, the more recent studies done by Lapenu and Zeller, 2018 affirm the disposition of the financial theory, and that foreign exchange movement indeed affects the net sales and assets of any multinational company, and this subsequently affects the net value of a company.
Developed by Irving Fisher, in his book ‘The Theory of Interest’ published in 1930. The main aspect of the book is that rather than use inflation rates, it uses the market rates to explain the foreign exchange rates movement. In the book, the author argues that the exchange rates are balanced out by changes in the interest rate. The theory argues that “real interest rates across countries was equal due to the possibility of arbitrage opportunities between financial markets which generally occurs in the form of capital flows” (Puci and Mansaku, 2016, p.249). The implication being that if there is equality in the interest rates, a country that has high interests will also have a high inflation rate, which will end lead to a depreciation of its currency in the long run. This is because the real value of a country’s currency will be affected by the high interest rate. It is the interest rate theory of exchange expectations that explains the rate fluctuations. If one would sum up the Fisher effect, it would imply that interests in appreciating currencies tend to be low enough to offset any gains or losses in the foreign rates. It is also means that in depreciating currencies, the interest rates tend to be high to withstand any losses or gains of the foreign exchange rates. The Fisher theory argues that high nominal rates caused by currencies that have high interests depreciate, and hence this has an impact on the inflation rates. Amidst all these arguments, one of the issues that emerge is whether the interest differential helps in any way to predict any future movements of foreign rates. Siaplay et al., 2016 argues that indeed there is a correlation between the interest rate differentials and subsequent changes in the foreign exchange rates, but there are notable deviations in the short run. This implies that there is an inaccuracy on the reliability of the said correlation.
This is a theory that recognizes that the value of any product or service should reflect the linear calculation of the total sum of factors of the market indices. There is an underlying expectation that throughout the production process, and the final phase to the consumer, there is an effect of the rate of change. This model helps in arriving at a price that aligns with the expected performance of the product or service in the market. The expectation is that the final price will be discounted at the rates conversant with the Capital Asset Pricing Model. If there is a variation in the asset pricing, it is the arbitrage that is expected to provide a baseline that brings it on course.
When one looks at the banking sector, not just in Liberia but rather in a global scale, there are some factors that have long been associated with financial stability and improved performance. According to Udeaja et al., 2016, the financial performance indicators in the banking sector are either internal or external, and they all have an impact on the output. The internal factors are the relevant factors that are within the cultural framework of the bank and are a consequence of the management structure and the resultant decisions. The external factors are beyond the scope of the bank, and can be sector-wise or even global, but have a ramifications on the profitability of microfinance banks. There has been a steady growth of microfinance banks in Liberia have been on an expansion phase, and there is a lot that can be learnt in the performance indicators to determine sustainability.
These are specific bank variables that affect the internal operational structure of the bank. Additionally, these factors can be easily manipulated by the bank, and easily differ from bank to bank. These factors include deposit size, liabilities size, credit portfolio, labor productivity among others. In a study carried out by Siaplay et al., 2018, these factors were generalized to form the CAMEL framework, which means Capital Adequacy, Asset Quality, Management Efficiencies, Earnings Ability and Liquidity. While the ideology of internal factors is broad, the paper confides itself to the CAMEL framework due to their correlation to the foreign exchange risk.
22.214.171.124 Capital Adequacy
Capital as a factor goes beyond the operational capacity but also the overall profitability of any bank. It has been defined as the total fund available that facilitates a bank’s operations while also acting as a buffer in case of adverse situations. Capital offers banks liquidity because of the unpredictability of deposits, and reduces any distress that may arise. Capital adequacy is the capital level needed by banks to withstand the risks such as operational, credit and market, which in turn help absorb the losses and protection from debtors. There have been arguments put forward by Cooper, 2019 which show that the capital adequacy is judged on the basis of Capital Adequacy Ratio (CAR). The CAR helps to show the ability of a bank to withstand any crisis. The implication is that CAR is directly proportional ta a bank’s resilience during a crisis. Additionally, the CAR also determines any expansion drives by a bank, and whether it can invest in risky but profitable ventures.
126.96.36.199 Asset Quality
It affects a bank’s profitability and includes: fixed asset, current assets, credit portfolio among others. Asset quality can be derived from its longevity, coupled with its loan capacity which is one of the main ways through which banks are able to generate most of their incomes. In microfinance sector, loans is a major asset because its portfolio determines the overall profitability by a large extent. For instance, the Credit Bank of Liberia is the largest microfinance bank in Liberia, and its ability to have a large client base means that it offers loans to a larger group of people, thus improving its overall profitability and standing. However, loans also pose the greatest risk since some clients do not meet their obligations, leading to delinquent loans. In Liberia, this risk is reverberated because of the civil war that characterized the nation, and which continues to threaten the social fabric of the microfinance sector. Non-performing loans are largely seen as the biggest proxies to asset quality (Clower, 2016). Scholars have long applied different financial ratios to develop an understanding of bank loans. Banks, including commercial banks, have a common desire to keep the non-performing loans to a minimum. The lower the non-performing loans, the higher the profitability of a bank.
188.8.131.52 Management Efficacy
A major study by Dorley, 2014, he identifies some aspects that also affect a bank’s profitability and are represented by factors such as total asset growth, earnings growth among others. Unlike other factors, it is a daunting task to capture, at least by use of figures, the impact of management efficiencies, and its total relation to a bank’s overall performance. The main reason is that management efficacy is also known as the operational management. It means that there is a lot of subjective evaluation involved in the process of seeking to validate management efficiency including quality of staff, discipline, and control systems among others. All these factors are largely dependent on a bank’s ability to rein on its internal systems, and its employees to follow through the expected code of operations. However, there are some financial ratios that can be used to determine whether the internal control mechanisms are effective. They include income maximization and reduction of the operational costs. If any of these ratios are unhealthy, they indicate that there is a systematic management failure. One of the financial rations that has been used in this process is measurement of operating profit to income ratio. If the operating profits (revenues) are high, it means that there is efficiency in the income generation and operational structure. Another proxy financial ratio that can be used to qualitatively measure the impact of management efficiency is expense to asset ratio. In short, it is the management that determines the operational costs, which in turn affects the overall profitability.
184.108.40.206 Liquidity Management
Liquidity has been defined as the ability of a bank to meet its obligations, especially to depositors. This makes it one of the main factors that affects the profitability of any financial institution. Idama et al., 2014, argue that a positive liquidity is often associated with bank profitability. The most valid way, the argument further states, to measure liquidity is through customer deposit to total asset. There has been a study carried out in Malaysia and China by Kirchstein and Welvers, 2016 that countered these findings. The study emphasized that it did not find any clear connections between liquidity level and a bank’s performance.
The main paradigm, according to Kyereboah-Coleman, 2017, about external factors is that they are neither predictable nor within the scope of control of the banking sector. Aspects such as political instability, Gross Domestic Product (GDP), Inflation and Interest Rates are dynamic and the banking sector can only deal with them as they arise. In Liberia, the country has faced civil strife over the past, and this has been one of the main reasons hampering its fiscal growth. If the GDP of a bank falls, the demand for credit decreases, and this affects the loan uptake of the banking sector and ultimately the profitability. In an economic boom, there is an increase in credit uptake, unlike during a recession which is usually followed by further problems such as high interest rates, which then pushes the inflation rates higher.
A prevailing belief is that the foreign exchange rate affects the financial decision-making, and also the profitability of firms. There have been findings by Khoury and Chant, 2018 that show that the foreign exchange risk is minimal in countries such as the US that have a competitive structure in their industry. The underlying aspect is that there is a need to have an empirical comparison on some of the views that have been presented over time to come up with a position that best combines all these views. For instance, one of the main reasons why the Euro was developed as a currency was to cushion European countries from the uncertainties of the international currencies. However, before one goes into the empirical paradigms, it is vital to start by developing an insight on the Liberian economy, and its microfinance sector.
Historically, Liberia has long been an agricultural country, which means that it has an underdeveloped manufacturing sector. This follows a trend in which most countries in Sub-Saharan Africa depend on agricultural and other primary activities for self-sustenance, and as a source of the much-needed foreign exchange, as most of them are net importers. Liberia also has a vibrant mining sector of iron ore, which coupled with timber and rubber account for more than half of the country’s revenue. According to a study carried out by Outlook, 2019, there were findings showing that in the 1950s and 1960s, Liberia experienced a rapid economic growth, rivalled only by Japan globally. Unfortunately, this rapid growth did not lead to economic development, which means that it did not absorb a large number of the population into the formal sector and developing new and technical skills for its masses. To the dismay of the masses, the people who benefited from this economic growth were the minority ruling class of Americo-Liberians, and this sowed seeds of discord through tribalism and social lines. Under this period, iron ore was the main income-generating activity in Liberia, but most of the revenues went to the foreign concessions that held the mining licenses for the sector. History dictates that by 1965, the Liberian Mining Company, established by Colonel Christie from the US, was the leading source of government taxes (Dorley, 2014). The industry, despite raking in huge revenues, even in today’s market, is labor intensive, and thus provides employment to very few Liberians.
The latest statistics provided by the World Bank Outlook, 2019 on the country’s economy, the institution has observed that the country experienced its largest and most stable macroeconomics growth from 2005-2013, backed by periodical gains and losses over the recent years. There have been factors such as the breakout of the Ebola pandemic that have led to a significant drop in the economic activities in the country. However, in 2010, the country was granted a loan of $4.6 billion, as declared by by the World Bank and the International Monetary Fund 2018 after attaining the Heavily Indebted Poor Country (HIPC) status. The main implication was that Liberia qualified for the global efforts that had been launched to provide debt relief to the poorest countries, as a way of promoting debt sustainability while enhancing poverty reduction strategies and economic growth, especially in countries with small GDP’s, such as Liberia’s of $3.2 billion. The International Monetary Fund 2019 report commends Liberia because of its ability to maintain inflation of single digit figures, as this shows that the poverty reduction strategies that continue to be implemented are finally bearing results. However, the report notes that there are areas of concern, especially the continued reliance on iron ore and rubber as the main sources of government revenue. Any shocks to the market dynamics of these two commodities often have a bearing on the economy, coupled with its use of the USD as a legal currency.
Source: World Bank Staff Calculations based on IMF and CBL data
*The tables above show the different sectors of Liberia’s GDP and how each contributes to the entire economy. Table 2 shows the global comparison and some of the indices that are vital in coming up to an objective comparative approach of Liberian economy. The economic outlook for 2020, in line with the effect of the COVID pandemic is that the GDP will contract by 2.2%, but the non-mining sectors are expected to shore up the recovery.
Liberia’s political stability since 2006 has been cited as one of the main reasons why its economic growth continues to be the highest in the Western Africa region, though the Ebola pandemic marked the lowest point of the journey. The HIPC program led to support from international institutions, but this ended in 2010. Interestingly, even after the program ended, the government started an expansionary program, spearheaded by reducing the withholding tax of its employees as a way of encouraging consumer behavior. However, the budget estimates show a continued reliance on foreign aid as a way of dealing with the deficits that often characterize government expenditure (IMF, 2018). The government further developed the Poverty Reduction Strategy (PRS) and its monetary policy was at the heart of these efforts.
The Central Bank of Liberia is the public institution mandated with directing the monetary policy in the country. The main goal of the bank is to maintain a “maintain broad exchange rate as the intermediate target and price stability as the ultimate target in order to achieve low inflation in the economy” (CBL, 2020). It has consistently relied on the sale of weekly auctions of its foreign reserves as a way of influencing the domestic monetary policy and maintaining a stable foreign exchange rate. It is common that in dollarized economies such as Liberia’s, the policymakers rely on the use of foreign reserves in keeping the exchange rate within the acceptable levels with an eye on price stability. A persistent failure for the Central Bank of Liberia is its inability to solve the dual currency regime. The Liberian economy relies on the USD as its primary currency, accounting for 60% of all transactions in the country (Central Bank of Liberia, 2019). It means that with the USD in the economy, it becomes very challenging for the central bank to control and maintain the necessary liquidity levels in the country.
With a dual currency regime, Liberia has a liberalized economy that allows flexibility in the interaction of the two currencies, with the value of each commodity being reflected in the market. It means that each of the currencies is competitive when it comes to determination of the value of market rates. However, this interaction has been one-sided with the Liberian dollar facing depreciation due to reliance on imports and inadequate foreign currency reserves. The consequence of this situation is that there is a surplus of the Liberian dollar and an open economy, which implies that the exchange rate becomes the only viable way to regulate the liquidity and domestic pricing. It explains why the CBL mainly targets a nominal exchange rate in its weekly auctions to stabilize the Liberian dollars by creating a predictability in the pricing of goods.
In summative view, the PRS was aimed at consolidating all government resources towards maintaining peace and stability, economic revival and creating good governance while availing services and developing infrastructure to the people. It would also be imperative to mention that these government efforts were guided by the United Nation’s Milleniun Development Goals (MDGs) which among other things sought to reduce extreme poverty by 4%, eradicate hunger and end child mortality, and this remains its long endeavor, though most of these targets had not been achieved by 2015.
Of interest is that the microfinance banks and institutions are not spared by government actions, or inactions in the economy. The PRS is one of the policies that have a direct bearing on the microfinance sector in Liberia. Importantly, the government must guarantee its willingness to support the microfinance sector, especially by supporting the predictability of the external factors such as political stability and stability in the economy, which ensures that people can access credit facilities, and the microfinance banks can operate within a predictable environment. The Access Bank of Liberia, the biggest microfinance bank in the country, has been making strides to provide financial services to the poor in Montserrado County. The government has an obligation to maintain institutional and personnel security to create an environment that serves the collective needs and wants of the masses, including the MFIs. In a study carried out by Earne et al., 2018, it was found that in a post-conflict country like Liberia, a stable environment and access to credit are integral in driving economic growth. This can only be realized if the clients are economically active and have access to economic activities, which means that they can meet the credit obligations.
Further studies show that for the microfinance sector to grow, there should be adequate stability to all parties engaged in the financial transactions, which basically means creditors and debtors. There have also been collaborating research which indicates that microfinance banks thrives in an environment with financial matrix of low portfolios and low default rates. These are very instrumental to the sustainability and growth of the microfinance sector.
Having established the pattern of microfinance sector in Liberia, it is imperative to focus on the microfinance sector and how it has evolved over time. Some scholars such as El-Zoghbi and Gahwiler, 2015 have pushed the notion of microfinance being a new phenomenon. However, on the other hand, research done by Johnson, 2020 shows that there was informal savings and credit facilities in developed and developing countries from as early as 1700s in Europe, as recorded by Jonathan Swift and who initiated the Irish Loan Fund System. This facility would provide loans to small scale farmers who could not afford collateral. There would be other developments such as pawn shops and eventually, in the 1800s, the first financial cooperative was established in Germany by Friedrich W. Raiffeisen, who is regarded as the father of microfinance.
From the 1970s, the use of microfinance started gaining traction, with a focus on giving farmers subsidies, and credit facilities from the government and non-governmental entities. Research done by Ledgerwood et al., 2017, indicates that these approaches were ineffective as they could not reach the target market, and also often resulted in a high number of delinquent loans. It was also found that the operating costs of the microfinance institutions could not be covered by the revenues generated. In 1980, according to Martin, 2019, there was a major turning point in the microfinance sector in the operational structure seeking to be conform to the aspects associated with conventional banking, including loan repayments and aggressive marketing to reach a wider market, and hence increase the profitability. Robinson 2014 argues that in the 1990s, the microfinance sector started to view itself as a formal banking alliance, not just one that sought to serve the poor. In his arguments, further collaborated by Rodrik, 2016, he states “the growing trend in the microfinance industry along the growth of microcredit institutions on the global scene enabled the diversification of microfinance to delve into the provision of other financial services such as savings and pensions” (p.28). This confirmed the long-held but untested paradigm that the poor also needed access to financial services.
The prominence of the microfinance banking became prominent following the development of the microcredit summit of 1997. The main goal of the summit was to map out a strategy on how to reach 175 million of the world’s poorest population, especially women, and bring them into the banking sector. The purpose of the summit was to come to an end in 2015, which the United Nations dubbed the International Year of Microcredit. While the majority of the microfinance has mainly been associated with helping the poor, at the onset of the 21st century, there was a change of tune.
Studies show that in an environment of well-designed and structured lending programs, there is a propensity to improve living standards of the poor as well as eradicate absolute poverty (van der Sterren, 2018). Additional studies have also shown that the impact of the microfinance activities is directly proportional to one’s income. This means that people who have higher incomes are likely to benefit more from microfinance facilities unlike people with lower incomes.
The Keynes ‘Treatise on Money’ of 1930, there is an argument pushed on the importance of the banking sector in economic development. The inclination is that the banking sector is critical to sustainable economic growth. Additionally, the perspective argues that financial credit “is the pavement along which production travels to just the extend that is required in order that the productive powers of the community can be employed at their full capacity” (Clarida et al., 2019, p.1700). As a way of reinforcing this argument, there is also a definition that money is from its utility, ability to settle contractual obligations in an economy. Keynesian perspective further argues that money is necessary in an economy for transaction, precaution and speculative motives. There is also a fourth motive, the financial motive, which implies that there is acquisition of capital as a means of acquiring assets to invest and create employment. Therefore, the Keynesian perspective argues that if there is liquidity in the economy, this stimulates economic actions, and leads to opportunities for the poor.
In a study done by Tyson 2017, he argued that financial intermediaries play an important role in spurring economic growth since commercial banks have control over firms and individuals who they give credit facilities. The implication, as pushed in a study by Vanek et al., 2014, is that the poor are often overlooked, and the microfinance banks are used to fill this gap. This reflects what has long been held, the need for capital accumulation as a way of building wealth. In short, the microfinance banks simplify the overall goal of economic development by opening avenues for distribution and access of credit to people who are otherwise overlooked by the commercial sector.
Pattern and Johnston, 2018 argue that there are risks associated with expenses, risks and problems for investing in microfinance institutions. One of the key challenges is that MFIs tend to have a small, if not limited, pool of resources, mostly less than $1 billion, against a large pool of target market (International Monetary Fund, 2018). In Liberia, despite the expansion of the microfinance banks, there have been problems such as poor infrastructure, illiteracy and inadequate staff competence have all been cited as some of the key aspects derailing the sector.
Comparing the Liberian microfinance sector can largely be seen into two categories; Solidarity Groups and Community-Based organizations. It has also been found that the lending capacities in Liberia, both in rural and urban areas have all been instrumental in job creation, expansion of banking services and social integration in an otherwise volatile country. The Solidarity Groups reach the poorest of the poor as they have their specific rules on how each person acquires loans, and collective responsibility for any defaulting. In short, one acquires a loan by demonstrating capability to foot the resultant obligations. This method has been lauded by scholars, as it reduces operational costs. Research has shown that microfinance banks should have systems that can track and offer small unsecured loans for those in the informal sector, with high repayment (Dorley, 2014). In Liberia, social capital is used as a key tool of determining suitability to acquire microfinance loans rather than outright collateral. It is the loan officers, who double up as community members, who follow the standardized procedures to make final judgments on prequalification. There are other internal control mechanisms, such as working with the government to enforce, or motivate payments, for those who default.
The second lending method utilizes Savings and Loan Associations (SLAs). The method is “exclusively based on participant savings and equity contributions as a basis of funding its operations” which means that some depend on external donors to remain afloat. Social units are the primary way of identification for SLAs to become operational in the country. It should be noted that SLAs tend to focus on people with a saving capacity, which means that those in the lower economic paradigm can be locked out.
A forward contract is defined as a consensus to either sell or buy a specific quantity of product of a foreign currency at a specific value to be settled at an agreed future date; or within a specific time frame. In foreign exchange, forward contracts help microfinance banks and investors a time to determine the vulnerability of a currency, and to plan when they can make a sale of a given quantity of a specific currency. This means that an investor’s portfolio is protected from any sudden changes in the exchange rate. There are deliverable and non-deliverable forward contracts, with the former settled in foreign currency, while the latter is settled for the gain or loss on the worth of the contract.
In a 2016 study carried out by Kim et al., on the Fortune 500 companies, he found that the use of forward contracts was popular, especially those that engaged in forex hedging. It remains to be popular even within the modern circles. The forward contracts are negotiated by two parties, with each party making a commitment to meet the obligations, whether there is a change of the circumstances or not. A forward contract cannot be transferred, and all parties have to fulfil the requirements, without involving any other parties, which ultimately leads to a loss on the side which seeks to amend a forward contract. In a study done by Fearon et AL., 2019, they argued that forward contracts can lead to total hedging of a firm, and demystify the risks, but the high costs of forward contracts make them prohibitive.
Pegg, 2020 argues that cross currency swaps is whereby “counterparties exchange equal initial principal of two different currencies by spot rate and comparative advantage” (P.25) and a third party offsets the default risk. Basically, two parties, usually a bank and a company, exchange denominations of one currency, but to be paid in another currency. The goal is usually to regulate liquidity of the undesired currency as a way of raising capital of currencies with minimal revenues. However, the swapping parties can also seek to exchange to a currency with operating revenues in future.
It has been defined as the changing of prices. For instance, when there is a devaluation of a currency of a subsidiary, there can be an increase in the pricing to cover the devaluation. This method has been faulted mainly because of the inability to regulate and predict the behavior of competitors, which means that a company or country can lose its competitive edge due to the movement of the exchange rate.
Africa has been experiencing positive economic growth over the last two decades. Good governance and improved macroeconomic management have been cited as the two leading factors towards this aspect (Berenbach and Churchill, 2016). However, the poverty levels in the continent continue to be a thorn in the flesh, with the United Nations stating that there has been a general inability to reduce the poverty levels by half under the United Nations Millennium Development Goals (UNMDGs). The inadequacy in the economic structure has been one of the main reasons why the continent’s microfinance sector has not fully developed, and Liberia serves as representation of most African countries. In a study carried out by Business Outlook, 2019, it was found that” MFIs in Africa were able to reach approximately 60.2 million borrowers and 70 million savers in 2019” (15), which shows that there has been a steady rise over the years. The loan portfolios for the continent has also reached in excess of USD 10 billion, and in 2007, the continent achieved financial self-efficiency for the very first time in its existence. The one constant that can be said about the continent is that its microfinance sector has been rising steadily over the years, but a lot remains. The continent has not developed its fiscal policy though institutions such as the African Development Bank (AfDB) have been vital in easing the foreign exchange risk by providing foreign currency to African countries at affordable rates. The reliance on donor funding for most of the microfinance banks means that there should be further efforts to economically empower the majority, who continue to live below the poverty lines (International Monetary Fund, 2018). The microfinance banks continue to do so, but the poverty levels show that a lot has not been achieved as yet.
One of the aspects that becomes evident is that there seems to be a lot of issues that emerge, especially when it comes to the microfinance sector. The foreign exchange risk needs to be seen as one of the factors, not as a holistic paradigm in itself. The literature developed has shown the essence of microfinance banks, and their critical purpose in serving both local and international goals. The microfinance banks act as a link between formal banking and the masses. It fills the gap, and tries to bank the unbanked. However, in most instances, the studies are largely quiet on how foreign exchange risk affects the very purpose of the sector. The research methodology sought to try and generate further knowledge on this issue.
This chapter gives a breakdown of the various research processes that were used in coming to the final conclusion of the paper. In data collection, there was adherence to the set code of ethics for research, and the focus is mainly on the execution.
A descriptive research design was used in this paper. The design is suitable as it allows accumulation and examination of data within the paradigms of research relevance to the financial process. Descriptive designs have been known to give an accurate representation of occasions, account of the traits, men and women, in as far as producing beliefs, behavior, abilities and enhanced understanding of a person, entity or an event. In line with further research by Cooper, 2019, the descriptive research design has also been found to give a vivid outlook of things, by showing aspects such as values, traits, attitudes and behavior. It means that there is a reflection of the threshold of what a research design should show; investigation plan and empirical evidence of the findings. Information evaluation and information series should be given as a framework in the studies. Therefore, after analysis of monetary performance and financial exchange risk, the study will provide unique and relevant strategies. The descriptive method was preferred because of its ability to help in giving a clear picture on the events the study wants to portray.
Population, according to Stock and Burton, 2014, is defined as a combination of people, animals, plants or even things, and from which data collection can be done. Target population, according to Stock and Burton, 2014, is defined as the elements, specific units or well-defined and refined set of people who are under scrutiny. The target population of this study included 15 banks, both commercial and microfinance in Liberia, and how they have been affected by the foreign exchange risk. All banks have been operational from for more than five years for a period up to 2019. The banks were picked through a consensus approach, which means that the data collected is from all the banks operational in Liberia.
In the study, the focus is on secondary data. It means that this data had been collected by the banks and other financial bodies in Liberia, but the data is relevant and applicable in the study. However, the study utilizes secondary data that was submitted by Liberian banks to the Central Bank of Liberia, and the Access Bank of Liberia is used as a representation of the microfinance banks in the country, specifically because of its longevity in the country. All the data is easily accessible from the Central Bank of Liberia website. All banks have been operational for the last five years, and this was done to ensure objectivity, completeness and relevance of the data used.
When it comes to data analysis, there should be concerted efforts to ensure that there is use of the right analytical tools to ensure that the research questions in the study are answered. In this case, the research focused on the relationship between foreign exchange risk in the microfinance banks and the overall financial performance of the sector in fulfilling their purpose to their client base. All the date from the website was sorted, edited and corded to ensure that it met the threshold for validity and quality. Additionally, the data was also subjected to the SPSS (Version 21) and generated charts and graphs, correlations, frequency tables and charts which helped in bringing out any regressions, and thus aiding in the overall analysis.
Multiple linear regression was applied to show the effect and extent of influence of the independent variable on the dependent variables. The choice of the regression model because it is a multivariate model, implying that the commercial banks’ ROA is a function of the foreign exchange risk management strategies that have been chosen.
In the study, there is adoption of the regression function, which is applicable to both the dependent and the independent variables.
Y = β0 + β1X1+ β2X2+ β3X3 + β4X4 + β4X4 + β5X5 + β6X6
Y = Return on Assets (ROA) of the microfinance banks in Liberia, and is a measure of profitability, thus acting as the dependent variable.
β0 – This is the Constant/Y intercept
X1 – Represents the forward contracts. It was measured by use of percentage change in the agreed market value compared to the agreed value among the different parties. The idea is that there is a focus on the change of exchange rates agreed by these parties, usually at a specific time in future.
X2 – Represents the cross currency swaps, and it’s measured through a percentage change in a currency’s value due to the exchange rate movements.
X3 – The options method, measured by premium changes paid upfront by parties in a transaction to avoid foreign exchange exposure
X4 – Lagging and leading, measured by use of the lost value of the soft currency, and the appreciation of the hard currency.
X5 – Price Adjustments, measured by the percentage change in pricing of commodities due to the foreign exchange movements.
X6 – This is the bank, Access Bank of Liberia, which was used as a control variable. The size was measured using the Natural Log of Total Assets.
ε – Error term
What needs to be seen from the above data is that X1, X2, X3 X4 and X5 represent some of the foreign exchange risk management strategies, and some of these methods have been discussed in the study. Additionally, all these methods have been applied in all the financial reports submitted to the Central Bank of Liberia as a measure of the foreign exchange management risk, and the study uses the specific data submitted by these banks under the foreign exchange management.
To further strengthen the study, all the data was subjected to the t-test, and this was necessitated by the small number of the sample size. A t-test is vital as it compares the value of any two samples. The inclination is that the t-test is vital in comparing actual difference in variation between two samples, and this is expressed as the standard deviation of the means.
Operation Definition of Variable
Return on Asset
|A measure of profitability, thus acting as the dependent variable. Shows the financial performance.
|X1||Represents the Forward Contracts||Measured by use of percentage change in the agreed market value compared to the agreed value among the different parties. The idea is that there is a focus on the change of exchange rates agreed by these parties, usually at a specific time in future.
|X2||Represents the Cross Currency Swaps||It’s measured through a percentage change in a currency’s value due to the exchange rate movements.
|X3||Represents the Options Method||Measured by premium changes paid upfront by parties in a transaction to avoid foreign exchange exposure
|X4||Represents Leading and Lagging||Measured by use of the lost value of the soft currency, and the appreciation of the hard currency.
|X5||Represents Price Adjustments||Measured by the percentage change in pricing of commodities due to the foreign exchange movements.
|X6||Represents the Netting||Measured using the Natural Log of Total Assets|
The above research analysis methods will act as a guide to the subsequent processes that follow in the research paper. The data collected shows the need to have mechanisms to cushion microfinance banks against the shocks of the foreign exchange risk.
In this chapter, the main focus will be on presenting the findings after data evaluation. It should be noted that these findings will be guided by the research methodology and objectives. The general objective of the research was to establish the relationship between foreign exchange risk and its impact on the financial performance of the microfinance banks. The data is gathered exclusively from the Central Bank of Liberia and from the available financial audited reports of the microfinance banks. The data was from a pool of 42 banks.
As a way of helping to have a background and foundation of the study, there was a focus on the trends of foreign exchange among Liberian banks from 2010-2014. The aim was to find a consistency in the financial performance as a consequence of the foreign exchange risk over a range of time.
Moreover, through a determination of the overall performance in the foreign exchange risk, from 2010-2014, all the operational variables of the study, as defined in the operations table in the previous table, observations were made on their median, mean, maximum, minimum, kurtosis and skewness were all enforceable.
The following findings were realized.
Table 4.1: Descriptive Statistics
There is also the use of correlation matrix in the study to establish whether or not there exists linear relationships between foreign exchange and the financial performance and profitability of the microfinance banks. Interestingly, the findings indicated that there was indeed a very but negative and significant relationship between the two variables.
The research further wanted to establish the suitability of the regression equation using coefficient of determination between the overall independent variables and financial performances. Well, the coefficient of determination indeed found a strength of the relationship.
There was also further use of the Durbin Watson (DW) test as a way of ensuring that the residuals of the models did not auto-correlate. The independence of residuals is one of the ways of that highlights a basic hypothesis of regression. The DW value is more than of the recommended value of 2.0 for residual independence, it can then be argued that while auto-correlation was present, it is not much significant.
Table 4.2 Correlation
|R (Correlation)||R Square
|Std. Error of the Estimate||Durbin-
Additional methods that was used was the analysis of variance (ANOVA) which facilitated the making of comparisons for more than two means, and this helps to show whether there is a significant relationship among variables (usually between independent and dependent variables). It is also a way of underlining the importance of the regression model. The findings show that there is a 0.004, which is the margin error, that the findings in the regression model could be wrong. In a statistical view, this is insignificant but adds to the significance of the model that has been used in the research analysis.
Table 4.3: Analysis Of Variance
The findings of the regression model are represented in the table below.
Table 4.4: Regression Model
- Dependent variable – ROA
ROA = 0.814 + 6.760*Options + 1.557*Forward Contracts + 2.140*Cross Currency Swaps + 0.360*Leading and Lagging – 0.036*Price Adjustments + 0.022*Netting
It is evident from the table that the culmination of options, forward contracts, cross currency swaps, leading, lagging, price adjustments and netting at a zero profitability is equal to ROA is 0.814. In the above table, there is a focus on how an increase in one of the methods, while keeping all other methods constant, affects the ROA. For instance, the table shows that an increase in price adjustments while holding all other factors constant leads to an increase in ROA as -.036 decrease in the ROA. On the other hand, increase in the options while keeping all other factors constant will lead to an increase in ROA by 6.760. The above table gives a breakdown on all other factors and how they have an impact on ROA.
Lastly, there was also the use of multicollinearity tests to establish whether there is a strong correlation between two or more variables in the regression model. In this model, variance inflation factor (VIF) and tolerance were used as predictors for multicollinearity. An independent variable is supposed to be inverse to tolerance, while tolerance shows any variance in an independent variable that cannot be accounted by any other independent variable.
The table below gives a summation of the findings.
Table 4.5: Multicollinearity
|Cross Currency Swaps||.496||0.504|
|Leading and Lagging||.375||0.666|
The findings show that the tolerance levels range from 0.492 and 0.496 while the variance levels range between 0.509 and 0.504. In the table, the findings show that there is a tolerance above 0.1 while the VIF was below 10, which means that there was no multicollinearity in the data.
In the determination of coefficients, there is a clear indication of the strong relationship between both the independent and dependent variables. It means that the independent variables ((Options, Forward Contracts, Cross Currency Swaps, Leading and Lagging, Price Adjustments, Netting) account for the profitability variations in ROA, and the ANOVA model shows a negligible (0.004) margin of error.
Significantly, the findings in the regression model show a consensus with findings by Yunis, 2017 which argued that “options on spot currencies are commonly available in the interbank over-the-counter markets, while those on currency futures are traded on exchanges” (235) and this is supported by the options findings, which are significantly higher than (0.001), against the realized data of 6.760. Additionally, there is a need to emphasize that currency options allow parties to trade their currencies at a specific rate, so long as this falls within the established time frame. According to Strauch and Strauch, 2019, this means that there is a call option by the party holding the currency.
This is the trend that is observed in the methods that have been used in data collection, except for the inefficiencies of the price adjustments. As has been noted before, the use of price adjustment is subject to other external factors such as competitors and government policy, which could be the reason for their reduced capacity (-0.036) to regulate foreign exchange risk in the banking sector. However, the variation is almost negligible, and also shows why there should be a focus by banks to focus on other methods for foreign exchange risk management.
The main objective of this research paper was to find the impact of the financial exchange risk in the microfinance sector. This chapter offers a summary of the literature that has been reviewed, give a detailed discussion of the data findings and then offer recommendations, both for the present and the future.
As has been mentioned before, the main goal of the research was to analyze the impact of foreign exchange risk on the microfinance banks. When one looks at the research, there is the use of both descriptive and inferential methods of data collection. In the descriptive aspect, there is an analysis of the relevant aspects and a breakdown on each variable that has been used in the study. On the other hand, there is also the use of the inferential methods, including the correlations and regression model to analyze and evaluate the effect of any interactions and the relationship between the dependent and independent variables. There was further use of the Pearson correlation to show the impact of foreign exchange risk and management on the overall performance of microfinance banks in Liberia.
One of the key aspects from the study reflects what has been known in the economic paradigm. In a study done by Sengupta and Aubuchon, 2018, it was observed that “many borrowing microfinance institutions (MFIs) are not adequately managing their exposure to foreign exchange rate risk” (207) and nothing could be further from the truth when one looks at the microfinance banks in Liberia. While this has not been mentioned before, the most common form of foreign exchange risk in Liberia microfinance sector is the devaluation risk. This means that a bank acquires foreign currency through debts, and then lends the acquired funds in the domestic currency. In the long run, there is likely to be a ‘currency mismatch’ as each of the two currencies are prone to fluctuations.
The trend found in the study shows one aspect associative with foreign exchange risk; their impact is mainly felt in developing countries, including Liberia. Multiple studies have shown that the popularity of MFIs in developing countries makes them highly vulnerable to foreign exchange risk (David and Mosley, 2017). Additionally, in a recent study done by the Consultative Group to Assist the Poor (CGAP) under the IMF, 2018, shows that more than 50% of all microfinance banks do not have any protection from the foreign exchange risk. Ironically, those who have put in place measures to protect themselves mainly put in place partial measures. One possible explanation, according to the survey, is that MFIs lack an understanding on how the foreign exchange risk affects their financial performance, and the extent of their exposure. It is such ignorance that makes most MFIs not to have 100% financial hedging for foreign exchange risk.
Microfinance institutions gained independence in the 1990s. The Central Bank of Liberia reports show that the banking sector in the country continues to post improved performance. However, the microfinance banks continue to post poor profitability associated with the inadequate uptake of loans, poor credit management and a poor credit culture. The global experiences have shown that use of microfinance banks can be used in post conflict countries such as Liberia. The banking sector can be channeled to become pro-poor but the small population served by the banks makes it challenging to accelerate economic growth. Under the objectives of the study, it is evident that there is a lot of untapped potential, and inability to reach all the unbanked segments of the population.
The main goal of the microfinance banks is to accelerate economic growth among the population. There has been one of the main aspects about the microfinance banks that is very much relevant in the Liberian microfinance sector. When one looks at the PRS policy, it was designed with a goal to ensure that microfinance banks would be vital in tackling absolute poverty among the youth and women. The jury is still out on whether the MDGs which ended in 2015 have been attained, but facts show that the microfinance sector has been on an upward trajectory.
An additional paradigm on the objectives show that the liquidity risk has an effect on the return on assets and return on equity, according to Johnson, 2020. There have also been findings that show that financial performance and financial risk cannot be separated, and both need to be evaluated as a pair. Research shows that the continued focus on financial performance is an accumulation of other factors such as inflation, competitiveness, stability among others. This means that the microfinance sector in Liberia needs to be seen in the context of the country, including the background of the country. Microfinance banks have been instrumental in pushing economic growth in the country but the effects of external factors such as a robust fiscal policy, or lack of it, have also been vital in inhibiting full potential of the sector.
Of importance is that microfinance banks in Liberia face the convertibility risk because of the dual currency policy in the country. The people who have been put in charge of the operational and strategic departments of the microfinance banks in Liberia have to contend with the risk of foreign exchange, mainly because of the country’s inability to streamline its currency, and by extension, its foreign exchange management. The findings show that unless the Liberian banks use different methods of foreign exchange management, such as forward contracts, they stand to be affected negatively by the foreign exchange risk. The main issue is that such methods of protecting the banks from foreign exchange risk are expensive, coupled with ignorance, and this ultimately leads to a situation in which the banks are left susceptible to foreign exchange risk. The microfinance sector in Liberia is on the verge of rapid growth but the low economic activity and a population with low credit rating continues to hamper these aspirations. Of consequence is that the strategies that have been developed by the government do not take into consideration the needs of the microfinance sector but rather the economic stability, and the need to maintain a fragile social unity. There is also reliance on foreign donors, which means that microfinance banks in the country lack complete autonomy required for financial institutions. In this case, there is an imperative to conform to the set standards by donors, which are different from the commercial banks operational mode. This further exposes the financial performance of microfinance banks. According to Business, 2019, banks with an advanced risk management have a greater credit accessibility, and also leads to an increase in the firm’s profits and productive assets.
The research shows that microfinance banks in Liberia, including the Access Bank of Liberia have a positive impact of working with the government in fighting absolute poverty in the country. It validates research findings that show that having the poor access finance services helps to bring economic development to them while influencing pro poor fiscal policies. Liberia is a peripheral country and provision of financial services to its largely poor population is an uphill task. There is also the danger of creation of livelihoods to the poor masses, which retaliates the need to have fiscal policies with minimal risks to cushion the clients. It also shows that in such a country, microfinance banks do more other than offer financial services. Microfinance banks are a way of meeting the people’s aspirations for the future. The years of stability in Liberia has led to an expansion of the financial services, and also consolidation of the poor masses towards economic liberation. It means that there should be a policy framework to empower the poor, and this agenda should include the need to have a robust microfinance sector. The microfinance banks can help improve the living standards and incomes of the clients by advancing credit services at affordable rates, and this requires a policy protection from the Central Bank of Liberia.
Based on the findings in the research paper and extensive look at the Liberian microfinance sector, the following recommendations should be given consideration.
- The Liberian government should invest and diversify its financial inclusion programs to reach people at village levels, considering the fact that microfinance banks do not have the capacity for such mass outreach programs.
- The political ideology in the country, which is often tribal and ethnic, should be integrated into the financial sector as a way of further entrenching the social unity that continues to be a precursor for economic growth in the country.
- The government should improve on physical infrastructure, especially roads and educational facilities to help build capacity and accessibility of the microfinance banks to reach the poor who are deep in the country.
- There should be an increase of the minimal credit amount given to the masses, as a way of distributing the risks, and increasing the profitability due to interest gained from these loans.
- The microfinance banks should operate with a clarity of mind, and the government’s insistence on a dual currency means that there is exposure to risks such as convertibility, which in turn magnifies the impact of the foreign exchange risk.
- Fiscal strength should be developed as a priority to help the microfinance banks have bargaining power among donors and among the international financial institutions.
- The microfinance banks should also invest in projects that can bring in maximum profits. This will improve the return on assets, and help banks cushion themselves from the foreign exchange risk through increased capital.
The study could not extensively analyze the dynamics of the banking sector, and rather focused on the foreign exchange risk. This means that there could be other key areas that affect financial performance of the microfinance banks which have not been addressed by the study. The choice of country, Liberia, acts as a hindrance because of the relatively infancy of the country in the financial sector. It means that there should be a comprehensive focus on other countries that have a longer existence than Liberia. Such a comparative view could be a way to see how best to improve Liberian microfinance sector. Additionally, the sample size is small, and thus could have missed on some factors relevant to the population. A larger sample should be used in future undertakings. Lastly, in this age of privacy, access ti banking information proved to be a daunting task.
There should be further study that focuses on other factors that affect the foreign exchange risk, especially actions by donors and global financial institutions. There are other parameters in the banking sector that affect the foreign exchange risk, and this should be consolidated in future research.
In the banking sector, there should be a focus on trends due to the dynamism of the global fiscal policies. The time period of consideration for the research is short and there should be studies that can at least go for a decade to capture the true extent of financial exchange risk in the microfinance sector.
Finally, the banking sector has been globalized and future studies should seek to have a global picture. This is the only way through which foreign exchange can be understood as a global phenomenon, because its impact supersedes domestic issues.
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