Wednesday, June 24, 2009

New Kiva Feature: Currency Risk Protection

We’re constantly working hard to improve the Kiva website for the lenders who use the site to lend money to entrepreneurs, for the entrepreneurs whose loans are funded on Kiva and for the microfinance institutions Kiva partners with who facilitate the loans on the ground (Field Partners).

One improvement we’ve been working on for some time relates to the way Kiva loans are affected by foreign currency fluctuations. Foreign currency has significant impact on our Field Partners, and we’re excited that we’ve created a solution we think will be really effective in addressing this problem.

The Foreign Currency Situation Today

All Kiva loans are made in US dollars.

Let’s use an example of a pig-farmer in Vietnam, whose loan is being facilitated by Kiva’s Field Partner, TYM Fund. When a Kiva Lender lends $25 U.S. to the pig-farmer, Kiva sends $25 U.S. to TYM Fund, who then disburses the loan to the pig-farmer. When TYM Fund posts to the Kiva website that a repayment has been made on the pig-farming loan, TYM Fund will then send Kiva the repayment, also in U.S. dollars. Kiva then sends the repayment back to the Kiva lenders, also in U.S. dollars.

The problem is, the pig-farmer doesn’t receive U.S. dollars from TYM Fund. She is receiving Dongs, the Vietnamese currency.

Therefore, at some point in this process, a foreign currency exchange must take place. For all partners disbursing funds in a non-U.S. dollar currency, the exchange takes place after they have received loan funds from Kiva, and before they disburse the loan funds to the borrower. So, in the case of the Vietnamese pig-farmer, TYM Fund receives the loan from Kiva in U.S. dollars, then exchanges the U.S. dollars for Dongs using their local bank in Vietnam, and then disburses the loan to the pig-farmer in Dongs. As repayments are made by the pig-farmer to TYM Fund, TYM Fund converts the repaid Dongs to U.S. dollars, before sending the repayments off to Kiva, to be distributed to the Kiva Lenders who contributed to the pig-farmer’s loan.

The Foreign Currency Problem

The problem occurs when the value of the local currency, in this case the Vietnamese Dong, fluctuates. For example, when the Kiva loan reaches TYM Fund, they might exchange the U.S. dollars for Vietnamese Dongs at a value of 1 U.S. dollar for 17,000 Vietnamese Dongs. However, on the day they exchange the Vietnamese Dongs to U.S. dollars and send repayments back to Kiva, 1 U.S. dollar might only be exchanged for 16,000 Vietnamese Dongs.

Currency fluctuations can go up or down – meaning that a local currency might sometimes increase or decrease in value compared to the U.S. dollar, depending on what is going on in the global economy. Currencies can fluctuate a small amount, or they can fluctuate a large amount. If a currency suffers a massive devaluation against the U.S. dollar, this will create a problem for the Field Partner who still needs to send U.S. dollars to Kiva, even though their local currency can no longer buy as many U.S. dollars as it once received. Currently, when a massive local currency devaluation occurs, Kiva’s Field Partners are forced to make up the difference out of their own funds. We call this the Foreign Currency Risk.

In 2008 alone, pressure due to the U.S. economic crisis has caused emerging market currencies to devalue relative to the U.S. dollar. For instance, the maximum U.S. dollar depreciation over a 4-month period experienced by Ukraine in 2008 was -39%. Other countries such as Indonesia, Mexico, Kenya, Pakistan, Bosnia, Herzegovina, Bulgaria, Uganda and Paraguay have experienced 4-month depreciations greater than -20%.

Accepting and repaying U.S. dollars carries this risk, and, when faced with such a risk, some microfinance institutions may charge higher interest rates to make up any losses, or they may choose not to work with Kiva at all.

Kiva’s Foreign Currency Solution

Kiva’s Microfinance Partnerships Team and Engineering Team have been working for many months on a new feature that will share the Foreign Currency Risk amongst Kiva’s Field Partners and Kiva Lenders in the case of a massive local currency devaluation.
The way the new feature works is that it limits the Foreign Currency Risk for Field Partners to a devaluation of 20%. So, if the Vietnamese Dong devalues 10%, 15% or 20% against the U.S. Dollar between when TYM Fund received the Kiva loan funds and when they made a loan repayment, that amount must be made up by TYM Fund. It’s not until the local currency devalues more than 20%, that the cost is shared with Kiva Lenders.

So, if a Kiva Lender makes a $25 loan to the pig-farmer in Vietnam, but when a repayment is made, the Vietnamese Dong has devalued by 21%, TYM Fund must make up the missing 20%, but the Kiva Lender will receive back only 99% of their loan value. If the Vietnamese Dong has devalued by 30%, TYM Fund would again make up the missing 20%, but the Kiva Lender would receive only 90% of their loan value, because Kiva lenders bear the cost of the additional 10% devaluation.

Why did we choose this solution?

Currencies fluctuate against each other every day. Most currency fluctuations can be accommodated by Kiva’s Field Partners. It’s the risk of a massive currency devaluation that presents the greatest danger to Kiva Field Partners.
By limiting the Kiva’s Field Partners’ currency risk, we give them a much greater ability to manage their risk. If Kiva Field Partners can be confident that the greatest currency devaluation cost they need to prepare for is 20%, this gives them a hard number that they can work into their budget.

By passing the additional cost of foreign currency devaluation to Kiva Lenders, Kiva keeps this additional cost out of the Kiva budget (which is, in majority, funded by the donations of Kiva Lenders) so that our efficiency levels remain high. By distributing this cost among many Kiva Lenders, we decrease the impact any massive currency devaluation can on any one party, as each Kiva Lender can choose to diversify their portfolio so as to expose themselves to minimal currency devaluation risk.

In summary, we hope that releasing this feature will:
  • Help drive down Field Partner interest rates
  • Allow microfinance institutions that have difficulty accepting and repaying U.S. dollars to work with Kiva
  • Reduce the risk of defaults arising from catastrophic currency devaluations
What’s happens now?

This new feature is being release tonight. However, that doesn’t mean that every loan will automatically pass on the risk of currency devaluation over 20% to lenders.

1 – Kiva Field Partners will now have the choice to “opt-in” to this feature; they can choose to manage all Foreign Exchange Risk themselves, or – by opting into the Feature – pass on the risk of currency devaluation over 20% to Kiva Lenders.

2 – You can see which loans have opted into the Foreign Exchange feature on the business page on the right side of the page under “About the Loan” in a section called “Currency Risk,” which has three statuses:
  • Covered – If the Field Partner has not opted-into currency risk sharing
  • Possible – If the Field Partner has opted-into currency risk sharing
  • N/A – If the Field Partner does not disburse funds in a local currency (if they disburse U.S. dollars).
3 – Once a Field Partner has opted into this feature, the Foreign Currency Risk will only be shared with Kiva Lenders for new loans. All loans which have already been added to the Kiva site – whether they have already been funded, whether they are still being funded or whether they are yet to receive funding – will not expose you to the risk of losing funds via currency losses. So, you always have the choice to lend to businesses that have a possibility of foreign currency devaluation over and above 20%.

For more information, visit Kiva’s Help Center here or watch this video, featuring two of Kiva’s Microfinance Partnerships Managers who can help put this feature into perspective.