As the spread widens between the two (targeted, and expected) this becomes correlated with the loss of credibility
By Colls Ndlovu
Pursuant to the recent successful launch of the Ndlovu Currency Confidence Index (NCX Index), the markets have responded positively with much enthusiasm to such an initiative given the importance of confidence in the valuation of currencies.
As previously explained, the level of confidence on monetary policy, hence currencies, can be measured by the difference between the official targets for the external value of the currency, the internal value of the currency and the markets’ expectations of these two variables.
The external value of the currency is reflected by the foreign exchange rate while the internal value of the currency is determined by the inflation rate.
The proximity between the official levels and the markets levels is what could be termed the level of credibility. As the spread widens between the two (targeted and expected) this becomes correlated with the loss of credibility.
The calculation of the currency confidence index begins with the assumption that the confidence level of the market as a whole has a beta of 1, that is to say, 100%. The currency confidence index then seeks to calculate the beta of the currency confidence relative to the market as a whole.
The closer to 100% is the beta of the currency confidence, the more the confidence on the said currency and vice-versa.
As explained in the previous article, the calculation of the NCX Index has entailed the computation of the inflation rate differentials as one variable while the foreign exchange rates differentials were used as the other variable.
The weighted average of the summation of these variable differentials equates to a metric which amounts to the loss of confidence. The inverse of this measured metric is the confidence level, that is to say the beta of the currency confidence level.
The NCX Index postulates that as loss of confidence in the currency increases, the level of confidence in the currency decreases. It stands to reason that policy makers should strive to increase the level of confidence towards a beta of 1, that is to say, 100%.
The key driver of currency values is inflation
The key driver of currency values is inflation. Given the centrality of inflation in monetary policy decisions, the quantity theory of money through its equation of MV=PQ is taken into consideration as one of the underlying assumptions.
The inflation rate for month 1 is used as a benchmark rate while the inflation rate for month 2 is used as the verdict of the market, that is to say, market rate.
In the case of Zimbabwe, these will be the confirmed inflation rates for two consecutive periods (.e.g. April and May). The confirmed official foreign exchange rate serves as the benchmark and is inferred from the weekly auctions that are conducted every Tuesday.
The foreign exchange market rates are obtained from the mark-to-market valuation of the currency using the fair value as obtaining from the markets on the day.
The standard deviations expressed by way of tracking errors for both variables (inflation rate and foreign exchange rate) are then divided by their respective benchmarks and the results expressed as percentages.
The weighted average of the summation of the resultant percentages is then computed and the figure obtained represents the market’s loss of currency confidence.
The inverse of the loss of currency confidence, that is to say, 100% minus loss of currency confidence, gives us the NCX Index expressed as a percentage.
Any movement towards 100% indicates confidence in the currency
The Ndlovu Currency Confidence model therefore postulates that as the NCX Index increases positively towards 100%, it is indicative of the markets’ gaining confidence on the currency.
Pursuant to these measures, monetary authorities can then intervene with appropriate policy responses to try and remedy the situation through corrective measures.
The NCX Index will be used initially in the Zimbabwean context and then rolled out to the global financial markets starting with key African economies like Kenya, South Africa, Nigeria, inter alia.
While today’s article concentrated on the technical aspects of the NCX index, the next article will address the potential usage and further applications of this ground breaking index.
In particular, the next article will deal with how ordinary people and the markets (consumers, buyers and sellers) can use the NCX index in their daily investment decision making processes.
Colls Ndlovu, a currency expert, is an award-winning economist and central banker, and is the inventor of the NCX Index.
See Launch of the NCX Currency Confidence Index
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