Abstract

The primary objective of this study is to investigate the effect of foreign exchange exposure on the financial performance of Microfinance Institutions (MFIs) in Buea Municipality, Cameroon. Specifically, the research examines the impacts of transaction exposure, translation exposure, economic exposure, and funding exposure on the financial performance of Microfinance Institutions (MFIs). Using descriptive and inferential statistics, comprising 192 employees of 21 Microfinance Institutions (MFIs) in Buea, the findings reveal that transaction exposure significantly negatively affects financial performance, indicating that fluctuations in exchange rates can severely impair profitability.

Translation exposure also demonstrated a detrimental effect, albeit to a lesser extent, suggesting that currency conversion processes create additional financial strain. Economic exposure was found to have a substantial positive correlation with financial performance, highlighting the importance of strategic management in mitigating risks associated with broader economic factors.

Funding exposure, while positively correlated, did not achieve conventional significance, indicating the need for deeper investigation. Furthermore, the study emphasizes the necessity for MFIs to adopt effective risk management practices, including hedging strategies and diversification of funding sources, to enhance financial stability. The results underscore the critical role of understanding foreign exchange dynamics in improving the resilience and sustainability of MFIs in the region.

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Microfinance is one of the economic activities that is geared towards building the capacities of the poor who are largely ignored by most of the large financial sector players among them commercial banks and other lending institutions (Hayes, 2019). The microfinance industry assists the poor by graduating them to sustainable self-employment activities by providing them with access to financial services like credit, savings and insurance (Kagan, 2020).

Microfinance Institutions (MFI) in the world were established to serve the poor population which is regarded by commercial banks to be of the highest risk to offer their loans and also considered to be in the class of “unbankable” because of their small savings (Kono & Takahashi, 2010).   Microfinance institutions (MFIs) have emerged as a pivotal tool in promoting financial inclusion and economic development, particularly in developing countries.

These institutions provide essential financial services, such as microcredit, micro-savings, and microinsurance, to individuals and small businesses that traditionally lack access to formal banking services. The growth and sustainability of MFIs, however, can be significantly impacted by various factors, including foreign exchange (FX) exposure.

Foreign exchange exposure is the risk associated with fluctuations in exchange rates, which can have a significant impact on the financial performance of MFIs that engage in cross-border transactions or hold foreign currency-denominated assets and liabilities (Adusei & Obeng, 2019). Understanding the effect of FX exposure on MFI performance is crucial, as it can inform decision-making and risk management strategies to ensure the long-term viability of these institutions.

Globally, microfinance institutions (MFIs) have demonstrated significant performance in client growth and outreach. By the end of December 2017, MFIs reached an estimated 139 million low-income clients, with loan disbursements totalling approximately $114 billion, reflecting a growth of 5.6% from 2016. The South Asia region leads in the number of MFIs, accounting for around 60% of total borrowers.

However, growth trends varied across regions: in South Asia, the growth rate declined from 13.4% in 2016 to 6.6% in 2017. Conversely, East Asia and the Pacific saw an increase in borrowing, rising from 10.6% to 18.1% in 2017. In America, the loan portfolio decreased by 1.1% during the same period (MFI Report, 2018).

In Africa, while the microfinance sector has been expanding, challenges such as regulatory constraints and economic instability have affected growth rates. Nonetheless, initiatives to enhance financial inclusion and support for underserved populations continue to drive the sector’s development across the continent.

In 2016, their global portfolio risk increased to 7.2 % compared to 4.7 % in 2015. For the year 2017, MFIs in Eastern Europe and Central Asia generated losses of 1.1% on ROA. South Asian MFIs on the other hand showed ROA of 3.5% while African MFIs showed ROA of 3.1% with low portfolio quality (Microfinance Barometer Report, 2018). According to Mohita (2019), there is a slow positive growth in the MFIs based on the global trend on assessments of operational and financial results of 762 MFIs worldwide.

The European microfinance sector has also experienced significant growth in recent years. According to the European Microfinance Network (2021), the total number of active borrowers served by European MFIs reached 1.8 million in 2020, up from 1.6 million in 2018. The total value of loans disbursed by European MFIs also increased, from €3.6 billion in 2018 to €4.2 billion in 2020 (European Microfinance Network, 2021 The performance of European MFIs has been influenced by various factors, including regulatory changes, technological advancements, and the impact of the COVID-19 pandemic. Notably, the European Union has implemented several initiatives to support the growth and sustainability of the microfinance sector, such as the European Progress Microfinance Facility and the European Fund for Strategic Investments (European Microfinance Network, 2021).

In West Africa, there was a noticeable increase in borrowings during the electioneering period in 2017. According to Blaine (2018), this increase amounted to 0.4%. The electioneering period is a time of heightened political activity, with campaigns, rallies, and various expenses associated with the electoral process. During this time, political parties and candidates often require additional funding to support their campaigns and activities. The 0.4% increase in borrowings suggests that the demand for financial resources during the electioneering period was significant. Political parties and candidates may have sought loans from banks, financial institutions, or even international sources to finance their campaigns.

These borrowings could have been used to cover expenses such as advertising, organizing events, mobilizing supporters, and other campaign-related costs. The attribution of the increase in borrowings to the electioneering period highlights the connection between political events and economic behaviour in West Africa. Elections are crucial moments in the political landscape, and they can have a significant impact on various aspects of society, including the economy. The need for increased funding during this period underscores the financial challenges faced by political actors and the importance of financial resources in the political process.

The 0.4% increase in borrowings in West Africa during the electioneering period in 2017, as indicated by Blaine (2018), reflects the heightened demand for financial resources by political parties and candidates. This increase highlights the financial challenges associated with political campaigns and underscores the interplay between politics and the economy in the region.

The impact of foreign exchange exposure on the financial performance of microfinance institutions is a topic of growing interest in the academic and practitioner communities. Several studies have examined this relationship, yielding important insights. Adusei and Obeng (2019) investigated the effect of foreign exchange risk on the financial performance of MFIs in Ghana. The study found that MFIs with higher levels of foreign exchange exposure experienced lower profitability and higher portfolio risk, indicating the significant impact of currency fluctuations on MFI performance.

Similarly, Tchakoute-Tchuigoua and Soumaré (2019) explored the relationship between foreign exchange risk and the financial performance of MFIs in sub-Saharan Africa. The researchers discovered that MFIs with higher foreign currency-denominated assets and liabilities tended to have lower profitability and higher risk levels.

Foreign exchange exposure can also affect the solvency and capital adequacy of MFIs. A study by Chijoriga and Nkuna (2015) highlighted that exchange rate fluctuations can lead to losses, impairments, and capital erosion, thereby affecting the financial stability and solvency of MFIs. Effective risk management practices play a crucial role in mitigating the adverse effects of foreign exchange exposure. A study by Sekhar et al. (2018) emphasized the importance of hedging mechanisms to manage foreign exchange risks. They found that MFIs employing hedging strategies, such as forward contracts or currency swaps, were better equipped to handle exchange rate fluctuations and minimize their impact on financial performance Geographic diversification can help reduce foreign exchange exposure for MFIs. A study by Cull et al. (2009) revealed that MFIs operating in multiple countries were better able to diversify their currency risk and mitigate the adverse effects of exchange rate fluctuations.

The regulatory environment in which MFIs operate can also influence their foreign exchange exposure and performance. A study by Dorfleitner et al. (2018) found that regulatory restrictions on foreign exchange activities can limit the ability of MFIs to manage currency risk effectively, thereby impacting their financial performance (Dorfleitner et al., 2018). Therefore, foreign exchange exposure can have significant implications for the financial performance of MFIs, affecting profitability, solvency, and capital adequacy. Implementing effective risk management practices, diversifying geographically, and considering regulatory frameworks are crucial for MFIs to mitigate the adverse effects of foreign exchange exposure and maintain financial stability.

MFIs often engage in international operations, such as accessing foreign currency borrowings or operating in multiple countries, which can expose them to foreign exchange risk. For example, MFIs may borrow in foreign currencies to fund their lending activities or expand their operations to new markets, which can lead to FX exposure (Tchakoute-Tchuigoua & Soumaré, 2019). The impact of these international operations on MFI performance can be both positive and negative. On the one hand, accessing foreign currency funding can provide MFIs with additional resources to expand their reach and serve more clients. However, if not managed effectively, FX exposure can have a detrimental effect on their financial performance, leading to lower profitability, higher portfolio risk, and increased operational costs (Salas, 2017).

In Cameroon, the microfinance sector has experienced significant growth, with MFIs playing a crucial role in providing financial services to underserved populations. However, the impact of foreign exchange exposure on the financial performance of Cameroonian MFIs, particularly in Buea Municipality, has not been extensively studied. A study by Ngoufo et al. (2022) examined the financial performance of 25 MFIs in Buea Municipality and found that FX exposure had a significant negative impact on their profitability and operational efficiency.

The study highlighted the need for Cameroonian MFIs to implement robust FX risk management strategies to mitigate the adverse effects of exchange rate fluctuations on their financial performance. MFIs in Buea that engage in international operations, such as borrowing or lending in foreign currencies, may encounter foreign exchange exposure. When an MFI borrows funds in a foreign currency and the local currency depreciates against that currency, it can lead to increased repayment costs for the MFI. Similarly, if an MFI provides loans in foreign currencies and the local currency depreciates, it may experience a decrease in the value of loan repayments received (MFIs report, 2022). The funding sources of MFIs in Buea can also contribute to their exposure to foreign exchange fluctuations.

If an MFI relies on external funding from international sources, such as loans or investments denominated in foreign currencies, it becomes susceptible to changes in exchange rates. Fluctuations in exchange rates can impact the cost of borrowing or the value of investments, potentially influencing the financial stability of the MFIs (MFIs report, 2022).

1.2 Statement of the Problem

Microfinance institutions (MFIs) in Buea Municipality, Cameroon, are essential for providing financial services to low-income individuals and communities. However, they operate in an environment characterized by significant fluctuations in foreign exchange rates, which can severely impact their financial performance.

This study focuses specifically on the independent variable of foreign exchange exposure, which encompasses transaction, translation, economic, and funding exposures. Transaction exposure arises from the potential impact of exchange rate fluctuations on the value of individual transactions denominated in foreign currencies, affecting cash flows and profitability (Jorion, 2009). This exposure is particularly relevant for MFIs engaged in cross-border transactions or holding foreign currency-denominated assets and liabilities, as it can lead to increased operational costs and reduced profitability (Adusei & Obeng, 2019). Translation exposure, also known as accounting exposure, refers to the effects of exchange rate changes on the financial statements of MFIs when converting foreign-denominated assets and liabilities into the reporting currency.

Such exposure can distort financial performance indicators, leading to significant translation gains or losses (Eun & Resnick, 2018). This distortion can complicate the assessment of an MFI’s true financial health and sustainability. Economic exposure pertains to the broader impact of exchange rate fluctuations on a firm’s market value and competitive position (Shapiro & Balbirer, 1999). MFIs operating in volatile economic environments may face challenges in maintaining financial stability and achieving sustainable growth due to the adverse effects of currency fluctuations on their overall operational strategies (Tchakoute-Tchuigoua & Soumaré, 2019).

Additionally, funding exposure refers to the risk associated with unfavourable changes in exchange rates that can increase the cost of servicing foreign currency-denominated loans (Brealey et al., 2020). Many MFIs in Buea rely on foreign funding sources, making them particularly vulnerable to exchange rate movements that could exacerbate financial burdens and lead to liquidity issues (Tchamyou, 2019). Despite various government reforms aimed at improving the regulatory framework and promoting financial inclusion within the microfinance sector, the financial performance of MFIs in Buea has consistently underperformed.

This persistent issue underscores the need for a thorough investigation into how foreign exchange exposure specifically influences the financial stability and operational efficiency of MFIs in the region. Understanding these dynamics is crucial for developing effective risk management strategies that can enhance the resilience and sustainability of the microfinance sector.

1.3 Research Questions

1. To what extent does transaction exposure affect the financial performance of MFIs in Buea-Cameroon?
2. To what extent does translation exposure affect the financial performance of MFIs in Buea municipality?
3. What is the effect of economic exposure on the financial performance of MFIs in Buea municipality?
4. To what extent does funding exposure affect the financial performance of MFIs in Buea municipality?

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