Learning FX

What to Know About Pro-Cyclical FX Currencies

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Why does Brazil complain about its currency appreciating and then complain when it depreciates? Why did India blame the U.S. for an aggressive monetary policy until it recently called that policy too restrictive? Why is Europe going through the same debt crisis over and over again? To better understand the answers to these apparently unrelated questions, we need to study the characteristics of currencies, their behaviour over the business cycle.

What to Know About Procyclical FX Currencies

A procyclical currency is one whose value increases as the economy grows and vice versa. In other words, some countries have currencies whose value appreciates when the economy expands and depreciates when the economy contracts. These are said to be procyclical. A cyclical currency, on the other hand, is one whose value tends to follow the economy’s ups and downs.

How to Determine a Currency’s Cyclicality

A currency’s cyclicality is usually calculated as the first difference of its real exchange rate, which is the relative purchasing power of a currency compared to that of another currency. Typically, the relative exchange rate is calculated as the ratio of the spot price (the price of the currency at the current time) to the forward price (the price of the currency at the future time). The forward price reflects the expected relative purchasing power of the currency at that future time.

How Does a Procyclical Currency Affect the Economy?

If a currency is procyclical, it does not appreciate at a faster pace than the economy does. A procyclical currency pays for a better quality of life for its residents, as its purchasing power increases with its economic growth. The economic variable that most influences the relative exchange rate of a currency is real GDP.

The Impact of a Procyclical Currency on Inflation

If the economy grows faster than the currency, prices of imports rise, and a tightening of monetary policy is required to keep inflation in check. On the other hand, if the economy contracts, then the currency will depreciate, and the monetary policy will become more expansionary to prevent the deflation of prices. In this sense, a procyclical currency can guarantee a healthier economy with less inflation.

The Impact of a Procyclical Currency on Business Cycles

A procyclical currency can quickly become pro-expansionary or pro-contractionary, depending on the latest news. For example, if the central bank is expecting inflation to accelerate and decides to raise interest rates, and then inflation slows down, that policy will be quickly changed. The opposite also happens: When a currency is pro-expansionary, it tends to create an asset price bubble, which is eventually followed by a crash and a recession.

The Impact of a Procyclical Currency on Consumption

A procyclical currency can have a negative impact on the economy because it can lead to the systematic overuse of credit. Its overuse creates the asset price bubble, which eventually collapses and leads to a recession. Procyclical currencies are also prone to political manipulation.

How Procyclical Currencies Affect Businesses

Procyclical currencies can also create problems for businesses. If a currency’s value is strong, then its price relative to the currency of its major suppliers increases, creating a cost-of-living imbalance. The cost of imported raw materials will be higher, which will therefore increase their price.

How Procyclical Currencies Affect Investors

However, if the currency is procyclical and the value increases, then foreign investment increases, and the currencies become less volatile. If a currency is strongly procyclical, then foreign exchange losses can be reduced by holding foreign assets.

Currency Cyclicality Index

The currency cyclicality index was created to illustrate how procyclical a currency is.

The cyclicality of a currency is said to be neutral if its current exchange rate is similar to its long-term exchange rate. Over the last 60 years, there has been a negative correlation between a currency’s cyclicality and its volatility. The cyclicality of the currency is said to be positive if its current exchange rate is more than its long-term exchange rate.

If a currency cycle is more than 1.5 times the difference between the real GDP growth rate and the interest rate, it is said to have a procyclical currency cycle. A procyclical currency cycle is one that tends to overheat the economy and then cause a recession.

Examples of Procyclical Currencies

The Hong Kong Dollar (HKD) is procyclical, as it reinforces the economy’s growth by increasing the purchasing power of its residents.

The South Korean Won (KRW) is another example of a procyclical currency, as the country has a strong manufacturing base and a relatively low unemployment rate. The country has a low level of inflation and, therefore, a low-interest rate.

The U.S. dollar is also procyclical, but it tends to overheat the economy more than the yuan due to the fact that basic interest rates in the U.S. are higher.

The Chinese Yuan (CNY) is also procyclical, but due to the country’s high levels of inflation and interest rates, it tends to overheat the economy less than the U.S. dollar and the euro. At the same time, the yuan is less volatile than the U.S. dollar and the euro, making it a good currency for investment.

The Argentine Peso (ARS) is a meta currency (a currency whose exchange rate is greatly influenced by the exchange rate between other currencies). The Argentine Peso is strongly procyclical and tends to follow the dollar’s cycle. The currency is of lower quality than the dollar: the economy is more volatile, inflation is higher and the economy is less innovative.

The Indian Rupee (INR) is procyclical but not as strongly as the U.S. dollar. The Indian economy is growing faster than the currency, with a higher inflation and interest rate. The rupee tends to overheat the economy less than the Chinese yuan, for example.

The Russian Ruble (RUB) is procyclical and tends to follow the dollar cycle. The currency is of lower quality than the dollar because of its high interest rates, volatility and inflation.

The Swedish Krona (SEK) is procyclical, but it is not overused as the dollar is, so it does not have the same potential to overheat the economy. The economy tends to be more stable than the U.S. economy.

The British Pound is procyclical, but the strong euro and the strong dollar prevent it from overheating the economy.

Which Country Characteristics Are Correlated with the Currency Cyclicality Index?

The cyclicality of the currency is strongly correlated with the levels of inflation, interest rates, and the exchange rate. The cyclicality index is also correlated with the debt-to-GDP ratio: The more indebted a country is, the more procyclical is its currency.

The cyclicality index is also correlated with the political risk of a country. If a country has a pro-cyclical currency, it is more likely to experience political crises.

What to Know About Procyclical Currencies

A procyclical currency can be a good thing for the economy if the cycle is moderate. The currency can also be used to gain political power if the cycle is very strong. Procyclical currencies have the advantage of encouraging their economies to grow at a faster pace. At the same time, however, they lead to asset price bubbles and can create recessionary periods.

On the other hand, procyclical currencies tend to overheat the economy, causing asset bubbles that eventually collapse and lead to recessions. Procyclical currencies also cause growth cycles that tend to be more erratic than stable.

In short, the positive side of procyclical currencies is that they are strongly correlated with the real GDP growth rate. The negative side of procyclical currencies is that they can trigger a recession, as they can create a financial crisis by increasing the inflation rate.

What Determines Currency Cyclicality?

The cyclicality of a currency depends on the economic cycle: The stronger the economic cycle, the more procyclical the currency. The cyclicality of a currency is also influenced by its government policies. For example, if a government wants the economy to grow, then it will print more money and lower interest rates, and the currency will become more procyclical.

The values of the cyclicality index are also influenced by the relative growth of the economy, the level of interest rates, and the rate of inflation. For example, if the country’s economy is growing much faster than the currency, then the currency will be procyclical. When the currency’s growth is stronger than the real GDP growth, then the currency is said to be countercyclical.

Trends in Procyclical Currencies:

The U.S. Dollar is currently the most procyclical currency. Its recent trend toward over-heating the economy is reflected in its cycle toward procyclicality.

The Chinese Yuan is also becoming more procyclical, as its economic growth is slowing down. At the same time, the Chinese economy is becoming more innovative, allowing exports to grow. This trend is making its currency more procyclical.

The Japanese Yen is not procyclical as it is overvalued. The yen tends to be strong when the U.S. dollar is weak, and it becomes weaker when the U.S. dollar is strong.

The British Pound is procyclical and tends to follow the dollar cycle, while Europe’s economy is experiencing stagnation.

The South African Rand is procyclical, but it was very procyclical in the 1980s and 1990s. It became less procyclical after that period as the country’s economy experienced a slowdown.

The South Korean Won is strongly procyclical, which is the opposite of how it used to be. A decade ago, the Won was procyclical, but the country has changed its ways since. Its strong manufacturing base and presence in the Asian markets allow it to grow at a fast pace.

The Australian Dollar is procyclical, but it is not overused as the dollar is. The Australian economy is also growing faster than the currency, so it is not as procyclical as the Chinese yuan and the U.S. dollar.

The Argentine Peso is strongly procyclical. This is a result of Argentina’s overvalued peso, as it tends to overheat the economy. The country’s economy is very unstable, so the currency tends to be procyclical.

The Russian Ruble is highly procyclical. The country’s economy is growing, but its inflation rate is high. The government does not control the economy, so the currency is procyclical.

The Indian Rupee is not as procyclical as the Chinese yuan. The economy tends to be more stable, and India has a growing economy. Its currency is not overused as the Chinese Yuan’s is. Due to its high inflation rate and its high debt levels, the rupee is still procyclical.

Are growth differentials coming to the rescue for the USD?

The U.S. Dollar currently is the world’s dominant currency and is used in many different markets, as well as being the currency that is most widely held in international reserves. As such, it tends to be the currency that is most procyclical, and its cycle is usually the strongest.

However, the U.S. economy’s growth rate is only recently starting to show signs of picking up again, after years of slow growth and the after-effects of the 2008 financial crisis, and the world’s economies are all growing at a faster pace than the U.S. economy’s growth rate. Due to this, the dollar’s cycle may not be as strong as it used to be.

In addition, many markets that use the U.S. dollar as the currency are becoming less procyclical due to the fact that the dollar’s cycles are now weaker than the growth rates of the countries that use it.

Conclusion

The cyclicality of a currency can influence the economy in many different ways. Currency cycles can lead to more volatile growth rates, leading to more asset price bubbles, which can lead to recessions. If you are a business person looking for ways to safely transact in a worldwide market, using a hedging system will help you work with other currencies with peace of mind.

If you are looking for a reliable, hedging platform, come to Bound. This is an auto hedging platform dedicated to making currency protection better for businesses. Contact us today!

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