Hybrid model of exchange rate determinants in Malaysia

Abstract

The nominal exchange rate determination has been one of the most challenging tasks in international finance. Macroeconomic fundamental analysis has dominated the studies of exchange rate movements over the long-run horizon. However, it is a consensus that macroeconomic fundamentals do not perform well in explaining the dynamics of exchange rate over short-run horizon. On the other hand, the microstructure approach and oil price obtained supportive evidence to explain the dynamics of exchange rate at short-run horizon. Thus, the aim of this study is to analyse the nominal exchange rate determination with a multidimensional view, such as macroeconomic fundamentals, oil price, and microstructure approach over long-run and short-run horizons in the context of Malaysia. To achieve this goal, two datasets are used in this study. Firstly, the study examines the impact of macroeconomic fundamentals and oil price on the nominal exchange rate using monthly data for the period of January 1994 to December 2017. The relationship among the determinants is examined in terms of combined cointegration, Dynamic OLS, and threshold cointegration. The results show that a significant long-run relationship exists among nominal exchange rate, macroeconomic fundamentals, and oil price using combined cointegration and Dynamic OLS. The empirical findings also highlight the existence of a significant threshold relationship between the nominal exchange rate and its determinants by Threshold Autoregressive and Momentum Threshold Autoregressive. In addition, the short-run adjustment of the exchange rate deviation from their longrun equilibrium values is determined by Momentum Vector Error Correction Model. The findings show that the short-run dynamics of the exchange rate in the long-run equilibrium path is being corrected through money supply, interest rate, and oil price in Malaysia. Secondly, this study analysed another dataset of high-frequency daily data from 2010 to 2017 using a nonlinear ARDL approach. The results show the nonlinear relationship between the nominal exchange rate and hybrid approach. The empirical findings indicate that instead of the order flow, the bid-ask spread has some informational content to explain the exchange rate movement. The association between the exchange rate and the bid-ask spread supports the view that liquidity effects play an important role in determining the exchange rate. Additionally, the negative changes in the oil price potentially act as the macroeconomic news announcement which plays a significant role in the determination of the Malaysian exchange rate. The empirical results allow for long-run and short-run asymmetric pricing impacts of a hybrid approach on the nominal exchange rate in Malaysia. The results of this study are useful in providing policy direction and practical implications for the monetary authorities and market dealers to employ interest rate for the adjustment of the exchange rate in the long-run and short-run horizons. In addition, the bid-ask spread and oil price should be considered as an influential exchange rate determinants in short-run in Malaysia. Future research potentially sheds light on the asymmetric oil price impact on the Malaysian exchange rate during the outbreak of Covid-19.