Pro and counter cyclicality of currencies – insights on depreciation

by **Cals** Mon 31 Aug 2015, 21:21

Pro and counter cyclicality of currencies – insights on depreciation

Saturday, 29 August 2015
By: SURESH RAMANATHAN

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Doing badly: Australian dollar banknotes of various denominations. The currency is among commodity-based currencies that are also faring badly.

IN business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be pro-cyclical. That is, any quantity that tends to increase when the overall economy is growing is classified as pro-cyclical.
Quantities that tend to increase when the overall economy is slowing down are classified as countercyclical.
In the case of currencies, currencies are seen as pro-cyclical if they appreciate in good times, countercyclical if they appreciate in bad times.
Pro-cyclical and counter cyclical currency movements, there is three key observations to be made:
> Economies that are commodity exporters and experience pro-cyclical capital flows tend to have pro-cyclical currencies.
>Economies with pro-cyclical currencies tend to restrict their capital accounts, perhaps as an attempt to reduce the degree of pro-cyclicality.
> When it comes to monetary policy, with pro-cyclical currencies the tendency is to pursue pro-cyclical monetary policy, however, in the past decade, there is disconnect between the cyclicality of currency and monetary policy. This disconnect reflects a decline in the fear of floating, as liberalization of capital flow takes precedence, which can be partially attributed to an improvement in countries’ net foreign asset positions.
In the case of Malaysia, a trading nation with strong leanings to commodity exports, there is reason to believe that the ringgit fares badly when commodity prices decline and export earnings erode.
But the key here being, Malaysia has liberalized its currency policy significantly within the past decade following the de-peg of the currency, which also tells us that as the currency policy inches closer towards a freer floating regime, the variable valve here being the currency, tends to absorb most of the shocks into the economy.
An observation that is worth noting is the fact commodity-based currencies are faring badly as well, these include the Australian dollar, New Zealand dollar, Indonesian rupiah, rouble, Nigerian naira, Kazakh tenge and the baht. But the currency regime that is being pursued in these economies vary, some with a total free float or even with a managed float with no predetermined path for the exchange rate.
The magnitude of depreciation also varies and this boils down to the degree of capital flow liberalization polices and how large it is as a commodity exporter.
Bottom-line, it may look like a “one size fits all scenario”, but the percentage of decline varies and the capital flow liberalisation policies differs between economies, and it is here the contention of policies comes into play.
In order to counter the pro-cyclical feature of currencies during turbulent periods, administrative measures becomes the corner stone of softening the blow from external shocks, these perhaps could include the six major points that was highlighted here in last week’s column.
Though it may not be fool proof and provide a long lasting effect, it nevertheless softens the blow from external shocks.
There are two facets to countering these shocks, namely identifying where the shock emanates strongly from, whether it is purely a decline in global commodity prices, outflow of funds in global equity/debt markets or competitive devaluation policies by neighbouring economies.
Once this has been identified, the second stage of identification would involve whether these shocks cause a liquidity problem in the domestic financial markets and whether these shocks are moving closer towards negatively impacting the real sector of the economy.
The appropriate policy response at this point of time for Malaysia, suggest there is a need to counter liquidity problems in the domestic economy and this can only come from administrative measures in the foreign exchange and interest rate markets.
Liquidity here would mean in the context of local and foreign currency, the imbalances in supply and demand for both local and foreign currencies in domestic financial markets tend to distort the working mechanism of interest rate and foreign exchange markets.
Once administrative measures have been introduced to soften the shocks, the effects are carefully monitored within a time frame, before engaging on real sector based economic policies and it is here where the gradual shift towards counter cyclical fiscal and monetary policies are introduced when it is warranted.
Until then, it is worth noting the salient feature of cyclicality of currencies, namely being a commodity exporter, how close is one towards a free floating currency regime and the more liberalized is its capital flow policies, greater is the shocks.

Dr Suresh Ramanathan is an independent interest rate and foreign exchange strategist who has spent 20 years in several onshore and offshore financial institutions. He can be contacted at skrasta70@hotmail.com