The Global Factor As The First Principal Component For The Weekly Movements Of The CEE4 Currencies

Since the beginning of the coronavirus pandemic in March 2020, the currencies of CEE4 countries (Czech Republic, Hungary, Poland and Romania) have exhibited similar short-term (weekly) dynamics^[1] but diverse mid-term trends against the USD. In the period from 15 March 2020 to 27 November 2022, the HUF depreciated against the dollar by 23%, PLN by 13% and RON by 8%, whereas CZK appreciated by 1% (Figure 1). Such a divergence was barely observed prior to the Covid outbreak as, during the two years preceding it, the CEE4 currencies showed a relatively similar 13-17% depreciation against USD. This suggests that the post-Covid divergence is not a technical event but, rather, that it has fundamental roots. In this article we take a closer look at the common and individual drivers of these CEE4 FX movements to show that it’s highly likely that for the past two years fundamentals have played a more important role.

Also, noteworthy, after March 2020, the CEE4 currencies differentiate in terms of their reaction to the initial one-month long risk off (from -3% for RON to -10% for HUF), the subsequent recovery of April 2020–June 2021 (from 10% for RON to 23% for CZK) and by the scale of subsequent depreciation (from -11% for CZK to -28% for HUF). It is also evident from Figure 1 that the difference in the relative performance of HUF against PLN and RON started to be more pronounced after the beginning of the war in Ukraine, suggesting some fundamental or political factors have been at play.

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Methodology of Global-Regional-Local decomposition

Factors at play in divergence of CEE4 FX movements

The divergence in the CEE4 FX movements since the Covid outbreak suggests that even though the pandemic was a powerful global event that had a similar effect on currency movements in the region, other factors have been at play, which deserves a closer look. In other words, in addition to global movements, domestic factors have played a role, and these are the key focus of this article.

To distinguish the factors behind the CEE4 FX movements, we use the global-regionallocal (GRL) decomposition, which is based on the methods of Principal Component Analysis. According to the framework, the dynamics of the USD vs any CEE4 currency can be expressed as the sum of three uncorrelated components: global, regional and local. This statistical framework allows us to decompose the divergent trends of CEE4 currencies against USD presented in Figure 1, as well as to identify the sources of shortterm exchange rate co-movement. In the latter case, this can be done by computing the contribution of GRL factors to the variance of short-term fluctuations.

We define the global factor as the first principal component for the weekly movements of the CEE4 currencies plus the other 14 EME currencies (RSD, TRY, ZAR, ILS, BRL, MXN, CLP, CNY, INR, IDR, KRW, PHP, SGD, TWD) against USD. Next, the regional factor is extracted as the first principal component of the remaining part of CEE4 currency movements. The local component is the remaining part of the exchange rate dynamics.

GRL decomposition of weekly fluctuations – it’s almost all about the global factor

Figure 2 reveals that the global factor, which accounts for between 64% for HUF and 82% for RON variability, is by far the most important determinant of weekly exchange rate fluctuations for all CEE4 currencies5. This very high correlation of the global factor with the US dollar index (DXY) indicates that, over the short run, the dollar’s value is driving CEE4 volatility. The contribution of the regional factor, which is correlated with the EUR/USD rate, ranges from 7 to 22%, whereas the role of the local component is relatively small, especially for PLN and CZK.

FX weekly fluctuations

Global = most important Regional = 7-22% impact Local = relatively small role

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1. The correlation of short-term (weekly) movements of CEE4 currencies ranged between 0.79 for HUF/USDRON/USD pair to 0.92 for PLN/USD-CZK/USD pair ↑