Source: The Wall Street Journal                      Date: 27 July, 2011

Global banks have figured out how to hedge against unexpected exchange-rate movements in the euro, yen and Swiss franc. But what happens when they try dealing with the MNT? Hedging foreign-exchange risks in major markets is becoming less of a problem for savvy institutions, but it is a growing issue for smaller companies that make philanthropic loans in tiny economies--investing known as microfinance, in which lenders such as Ulaanbaatar-based Xac Bank offer USD2,500 loans to local entrepreneurs to try jump-starting economic development in small countries.

These kinds of loans are rapidly spreading around the world as rich-country investors make charitable loans to people who otherwise wouldn't usually have capital. One recent report says microfinance banks currently have about $6 billion in outstanding international loans.

The problem is, the countries that are poor enough to need microfinance lending usually have extremely illiquid currencies, which make them all but impossible to hedge against. Banks are afraid to send large sums of their currencies there because if the local currency suddenly devalues, the borrowers can't pay back their loans and the lenders end up short.

What happens when microfinance lenders try to make loans without this hedging help? Mongolia's XacBank offers micro-loans to nomadic yak herders and small manufacturers. The bank has to make the majority of its loans in USD even though its borrowers need MNT, a currency that is extremely volatile because it's so illiquid, says Mr. Ts. Banzragch of the bank's treasury department. That forces the bank to make convoluted loans in which it deposits dollars from abroad into a local bank, then switches them to MNT, and then lends those out to herders. This leaves XacBank exposed to the risk of the MNT devaluing and borrowers having no way to fully repay their loans.

Although the world has been moving toward freely floating and potentially volatile exchange rates for three decades, people in the microfinance field didn't take into account the idea that they could lose drastic sums of money because of currency fluctuations until the 2008 financial crisis. Enter TCX, a USD750 million fund founded in 2009 and backed by two dozen government agencies, including the development banks of Germany, Belgium and Japan. The fund holds huge quantities of currencies from emerging markets such as MNT. The idea behind holding all of these currencies is that if one of them unexpectedly moves in value, another's movement will balance it out, similar to how hedge funds operate.

Banks that are interested in working with TCX know that being government-backed, it isn't always necessarily trying to squeeze every last penny out of its business deals like other major banks.