The wider the distance is, the gloomier the markets confidence on the currency is
By Colls Ndlovu
NCX Index as @30 September 2020 =31%
Implying a loss of confidence of 69%
The recent trial runs of the Ndlovu Currency Confidence Index (NCX Index) have provided the markets with an idea about the whys and wherefores of the currency confidence inclusive of its importance in the valuation of currencies.
The level of confidence on monetary policy, hence by extension, currencies, can be measured by the differences 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 benchmark and is inferred from the weekly auctions
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%.
To be sure, and to reiterate, as explained in the previous postulations, 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 annual inflation rate as calculated by the government statistical agency is compared to the governmental inflation target as prescribed.
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 difference between the two becomes one of the bivariates together with foreign exchange side of the differences.
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.
As explained in previous articles in this publication, the model therefore postulates that as the NCX Index increases positively towards 100%, it is indicative of the markets’ gaining confidence on the currency.
The obverse of this statement is correct, that is, as the NCX index decreases towards zero, this would be indicative of the markets losing confidence in the currency.
At 31%, the confidence is just too low
Even though the index has been launched primarily in the Zimbabwean context given the country’s episodic currencies, it will be rolled out to the global financial markets starting with key African economies like Kenya, South Africa, Nigeria, inter alia.
The September 2020’s NCX index for the Zim currency came out at 31% implying a worrisome loss of confidence of 69%.
These numbers of course are computed from the bivariates of inflation and foreign exchange rates on the one hand, and the multivariates arising from their differentials as explained above.
At 31% the confidence level is just too low but it is indicative of September’s horrendous inflation rate relative to the government target, and also the still stubborn spread between the official auction rate and the marked-to-market weighted average parallel rates.
Consequently, from a policy viewpoint, the monetary authorities need to strive to push the confidence index towards the neighbourhood of 100%.
For the ordinary magwinya-eating person like me and others, the key thing to watch on the NCX Index is how far is it from 100%. The wider the distance is, the gloomier is the markets confidence on the currency.
Inversely, the narrower the distance is, the more optimistic is the markets on the currency. The NCX index will be published every month with immediate effect ahead of the inclusion of other regional currencies.
Colls Ndlovu, a currency expert, is an award-winning economist and central banker, and is the inventor of the NCX Index.
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