This study presents an attempt to investigate the impact of exchange rate misalignment on capital inflows in Malaysia. Specifically, a precise threshold value is estimated to examine when exchange rate misalignment suppresses capital inflows. To pursue these objectives, this study relies on the endogenous threshold analysis as of Hansen (1996, 2000).
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Results suggest that misalignment in terms of currency overvaluation, has a negative and significant effect when overvaluation is more than 15 percent. This estimate is consistent and robust despite the changes in the choice of explanatory variables.
Foreign direct investment (FDI) has served as an important engine of growth via skills and technology transfer, creation of employment opportunities and expanding the capital stock in Malaysia. Since the 1997 Asian financial crisis, Malaysia is no longer the top 10 host for FDI. In fact, the rate of growth of FDI has dramatically decrease compared to that of the early 1990s. This is partly due to reverse investment (Mat Zin, 1999) and declining dependence on FDI to finance growth. However, this may also indicates the declining competitiveness of Malaysia in attracting FDI which warrants empirical research since it would be vital to investigate which factors that contributed to the deterioration of competitiveness. Since early 1980s, real exchange rate misalignment has become a standard concept in international macroeconomic theory and policy (Razin & Collins, 1997). Hence, this study focuses on exchange rate misalignment as an indicator of capital inflow competitiveness in the case of Malaysia. Malaysia provides an interesting case as it is one of the largest recipients of FDI amongst its ASEAN counterparts. Another advantage of undertaking a single country study is the ability to delineate the assumption that countries are similar in terms of social, cultural, economic and political background (Sun et al., 2002). Therefore, only relevant economic determinants are accounted for to suit the Malaysian environment.
The objective of this paper is to investigate the empirical relationship between capital inflows and exchange rate misalignment. Whilst existing literature focuses on the role of exchange rate, this study takes a step further to examine the impact of exchange rate misalignment on capital inflows. Specifically, we estimate a threshold value at which misalignment begins to significantly affect capital inflows. To the best of our knowledge, no published study has attempted to estimate a threshold value for exchange rate misalignment in Malaysia. Hence, this study intends to fill this gap. Based on the endogenous autoregressive threshold (TAR) model developed by Hansen (2000), we split the sample into high and low misalignment regimes. Results suggest that exchange rate misalignment due to overvaluation is detrimental to the influx of capital inflows. The next section provides a brief overview of FDI in Malaysia followed by a brief explication of the theoretical model and review of literature.
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