The current issue and full text archive of this journal is available at www.emeraldinsight.com/1753-8394.

htm

Towards an Islamic international nancial hub: the role of Islamic capital market in Malaysia
Rosylin Mohd. Yusof and M. Shabri Abd. Majid
Department of Economics, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia (IIUM), Kuala Lumpur, Malaysia
Abstract
Purpose In line with the governments policy to promote Malaysia as an international hub for Islamic banking and nance, the purpose of this paper is to evaluate the dynamic effects of both Islamic and conventional stock markets on foreign portfolio investments. Design/methodology/approach First, the paper explores the short and long-run relationships between (FPI) and three markets, i.e. the goods, money, and securities market. Second, the paper attempts to examine the relative importance of the three markets in accounting for variations in FPI. Consistent with earlier studies, the goods market variable considered is real income (Y). The money market variables tested are the broad money supply (M2), treasury bill rate (TBR) and the US Federal Fund rate (FFR), while the security market is represented by both Kuala Lumpur Shariah Index (KLSI) and Kuala Lumpur Composite Index (KLCI). Findings The ndings of the study indicate that among the three markets studied, the securities market in Malaysia (both conventional and Islamic) is the most signicant market in attracting FPI into the economy. This implies that to a certain extent, the governments effort in promoting Malaysia as the international hub for the Islamic capital market has been successful. Originality/value The paper suggests that further efforts need to be enhanced in promoting Malaysia as the International hub for the Islamic banking and nance. The papers ndings shed some light on the policy ramications pertaining to attracting foreign investors into the ICM in Malaysia and in moving towards a more globally competitive capital market. Keywords Islam, Malaysia, International nance, Money markets, Securities markets, Portfolio investment Paper type Research paper

Islamic capital market

313

1. Introduction The recent globalization of capital markets in both developed and developing economies have attracted the interest of researchers in the last few decades. One of the main features of globalization in capital market focus is the international equity ows (Kim and Wei, 2002; Durham, 2004; Goldstein and Razin, 2006; and Baek, 2006). Theoretically, international equity ows comprise of two components, i.e. Foreign Direct Investment (FDI) and Foreign Portfolio Investments (FPI). According to Rose (2005), the essential difference between the two is control. Portfolio investment merely involves purchasing securities to hold in order to receive interest, dividends or capital gains, while FPI refers to the purchase of land or the acquisition of ownership shares in an attempt to control a foreign business rm.
The authors would like to thank the Research Management Centre, International Islamic University Malaysia (IIUM) for funding this research project.

International Journal of Islamic and Middle Eastern Finance and Management Vol. 1 No. 4, 2008 pp. 313-329 q Emerald Group Publishing Limited 1753-8394 DOI 10.1108/17538390810919628

IMEFM 1,4

314

Numerous studies have been conducted on foreign equity ows, namely the FDI and FPI for both developed as well as developing economies. Goldstein and Razin (2006) developed a model of trade off between FDI and FPI. By analyzing the patterns of investments obtained in equilibrium for different parameter values based on management and efciency and liquidity shocks and resale prices, this study nds that direct investors are more informed about the fundamentals of their projects and in turn, enable them to manage their projects efciently. At the macro level, the model developed by Goldstein and Razin (2006) also documents empirical evidence that developed economies attract larger shares of FPI than developing economies. In addition, the developed economies with higher levels of transparency are expected to have smaller differences between withdrawal ratios of FPI than those of FDI. Liljeblom and Lound (2005) investigate the determinants of foreign portfolio investment ows into the Finnish stock market, from which restrictions of foreign investments were removed in 1993. By employing company specic data on the degree of foreign ownership and applying the multivariate pooled time series regression, the study asserts that foreign investment ows are signicantly related to variables such as investment barriers (proxied by dividend yield, liquidity and rm size), and protability and risk-related variables. A number of studies have also been conducted on the real effects of foreign portfolio investment and its link to economic growth. Durham (2004) examines the effects of FDI and FPI on economic growth using data on 80 countries for the period 1979 to 1998. By employing sensitivity analyses, simultaneity bias and case selection, the ndings suggest that FDI and Equity (FPI) and (EFPI) do not have direct and positive effects on growth. This therefore suggests that leaving the nancial markets alone is not a good way to encourage them as unfettered capital ows do not necessarily inhibit economic growth (La Porta et al., 1997). Studies on FPI in developing economies are also gaining ground in the nancial economics literature in the last decade. While several studies mainly focus on the asymmetric information between domestic and foreign investors (Gordon and Bovenberg, 1996; Kang and Stulz, 1997; Brennan and Cao, 1997), Kim and Wei (2002) examine the trading behaviour of foreign portfolio investors in Korea before and during the 1997 currency crisis. The study, adopts the metric proposed by Grinblatt et al. (1995) and later modied by Kaminsky et al. (1999) to analyze the trading behaviour of the foreign investors in the Korea Stock Exchange for the period December 1996 to June 1998. The empirical results of Kim and Wei (2002) suggest that Korean branches/subsidies of foreign institutions or foreign individual investors living in Korea are less likely to engage in positive feedback trading and less likely to engage in herding than their non-resident counterparts. In the recent years, international investors and researchers have been focusing more attention on the emerging markets of Southeast Asia. Equity investment in these countries has been able to provide not only attractive investment opportunities to foreign investors but also conducive nancial landscape to encourage more international equity inows. In fact, stock markets in these economies have recorded tremendous growth in the recent years. As at December 2005, the ASEAN-5 (Indonesia, Malaysia, Singapore, Thailand and the Philippines) domestic market capitalization accounts for about USD 603 billion, with total value traded amounting to USD 313 billion. Indeed, this is comparable to Borsa Italiana, with domestic capitalization of

about USD798 billion (World Federation of Exchanges, 2006). In identifying the pull, push or market sentiment variables for FPI ows to Asia and Latin America, Baek (2006) nds that the factors that push and pull FPI differ between Asian and Latin American economies. Favourable domestic economic conditions were found to be insignicant in attracting FPI in Asia, while strong economic growth is somewhat signicant in pulling the FPI into Latin American economies. Despite the empirical interest in international equity inows, fewer studies have been conducted on the link between FPI and the real economy, namely, the goods, money and securities markets. In an effort towards promoting an international Islamic nancial hub in this region, particularly Malaysia, comparative studies on the effects ` of conventional vis-a-vis Islamic capital market on attracting FPI is meagre. By employing the most recent technique in time series analysis, that is autoregressive distributed lag model (ARDL), this study seeks to investigate the short and long-run dynamics between (FPI) and both the conventional and ICMs for the period 1999:Q1 to 2006:Q4 in Malaysia. The nding of the study hopes to shed some light on the policy ramications pertaining to attracting foreign investors into the ICM in Malaysia in moving towards a more globally competitive capital market. The rest of the paper is organized as follows. Section 2 provides a brief overview of the Malaysian capital market. The formulation of the hypothesized model, the specication of the empirical framework and the description of data used in the study is in turn explained in Sections 3 and 4, respectively. The empirical results and discussion of the ndings are presented in Section 5. Finally, Section 6 summarizes the main ndings. 2. Malaysian capital market: an overview The Malaysian stock market is one of the most prominent emerging markets in the region.[1] The Malaysian Stock Exchange was initially set up in March 1960, and public trading of stocks and shares commenced in May 1960 in the clearing house of Bank Negara Malaysia. The Capital Issues Committee (CIC) was established in 1968, to supervise the issue of shares and other securities by companies applying for listing or already listed on the Exchange. Following the termination of the interchangeability with Singapore and the oating of the Malaysian dollar, the Malaysian Stock Exchange was separated into Kuala Lumpur stock exchange (KLSE) and Stock Exchange of Singapore (SES) in 1973. In 1992, the ICM[2] was introduced in the Malaysian economy. Its existence is reected by the presence of Islamic stock-broking operations which include Islamic indices, Islamic unit trusts and a list of permissible counters in the KLSE as issued by the Securities Commission (SC). The main feature of ICM is its activities are guided by Shariah injunctions. Precisely, ICM represents an assertion of religious law in the capital market transactions where the market should be free from the elements such as usury (riba), gambling (maisir) and uncertainties (gharar). There are two major components of the Islamic corporate securities market, namely Islamic debt securities market and the Islamic equity market. Currently, there are three Islamic Indices; the RHB Islamic Index (RHBII) introduced in 1992, the KLSE Shariah Index (KLSI) launched in 1999, and the FTSE-Bursa Malaysia (FBM) Emas Shariah Index launched in January 2007. Following the successful launch of these Islamic indices, Bursa Malaysia has further expanded its index series with a new

Islamic capital market

315

IMEFM 1,4

316

Shariah tradeable Index, the FBM Hijrah Shariah Index to meet the demand of local and foreign investors who are keen to invest in securities approved by the Islamic principles of Shariah. The launch of the countrys rst Shariah tradeable Index marked another signicant milestone in the development of key initiatives to enhance the attractiveness of the Malaysian ICM to domestic and global investors. Designed using FTSEs global indexing standards, the FBM Hijrah Shariah Index is an internationally accepted benchmark which will increase the Malaysian ICMs competitiveness (Security Commission, 2007). In the recent decades, the Islamic nancial market in Malaysia has gathered a signicant momentum in attracting international equity ows from both Muslim and non-Muslim international investors. Indeed, Malaysia, up to this date, is recognized as spearheading the burgeoning growth of Islamic banking and nance within this region. As at 31 May, 2005 there are about 816 Shariah-compliant stocks. These stocks represent about 82.5 per cent of the total listed companies in Bursa Malaysia and account for a total of 64 per cent of market capitalization. In fact, as at 31 December 2004, 36 per cent of all Shariah listed equity funds in the world are listed in Bursa Malaysia. The total value of these funds stood at USD 1.8 billion compared to total of USD of ve billion worldwide. Against this backdrop, this study seeks to assess the signicance of ICM in attracting FPI into Malaysia. 3. The hypothesized model The foundation of our hypothesized model is based on the interrelationships among the four markets, namely the goods market, the money market, the securities market and the labour market. However, according the Walras law, any one of these markets may be dropped in the analysis. Based on the literature, the labour market is usually dropped in the analysis of securities market (Wongbangpo and Sharma, 2002). Thus, this study examines the interrelationships between the FPI and the three other markets, i.e. the goods market, money market and securities market. Consistent with previous literature (Chen et al., 1986; Mukherjee and Naka, 1995, Wongbangpo and Sharma, 2002), the goods market variable chosen is the real income (Y), while the money market variables are the three-month treasury bill rate (TBR) and the real money supply (M2). Lastly, the securities markets are represented by both Kuala Lumpur Composite Index (KLCI) and (KLSI). In order to capture the international inuence on the net (FPI) and (NFPI) in Malaysia, we have also included the US Federal Funds rate (FFR) and the Malaysian real effective exchange rate (REER). Thus, we investigate the short and long-run dynamics between the (NFPI) and the above-mentioned three markets. Specically, our empirical model can be represented as follows: For conventional stock market: NFPI f Y; M2; TBR; KLCI; FFR; REER For Islamic stock market: NFPI f Y; M2; TBR; KLSI; FFR; REER According to the simple discounted present value model (Liljeblom and Stenius, 1997; Ibrahim, 2002; Ibrahim and Jusoh, 2001), stock prices are determined by the future cash

ows to the rm and discounting rates. Changes in these factors which may be due to changes in macroeconomic variables may, in turn, affect the stock market as well as FPI. In an open economy such as in Malaysia, corporate cash ows are inuenced by the changes in the macroeconomic variables such as national income, money supply, interest rate as well as the exchange rate. Following Geske and Roll (1983), Chen et al. (1986), Mukerjee and Naka (1995), Wongbangpo and Sharma (2002), among others, we hypothesize that there exists a positive relationship between net foreign investment and the level of real economic activity measured by real income (Y). The level of real economic activity will most likely inuence the rms protability via increased output, resulting in an increased rms expected future cash ows and in turn encouraging FPI into the economy. As for money supply (M2), it may have a positive or a negative impact on NFPI via portfolio substitution. According to Dhakal et al. (1993), a change in money supply causes a change in the equilibrium position of money balances in relation to demand for other assets. Ceteris paribus, an increase in the supply of money leads to an increase in the supply of money balances and excess demand in other assets and thus creating an upward pressure on equity prices and making it more attractive to international investors. Contrarily, a negative effect of an increase in money supply may be perceived as creating a downward pressure on stock prices and therefore inversely affecting the FPI. We further hypothesize that interest rates and NFPI are negatively related. According to the general view in nance, an increase in interest rate adversely affects the stock prices, which then raise the required rate of return of nancial assets. In this study, the interest rate as measured by TBR is regarded as the opportunity cost to holding equity shares for other assets within their portfolios. Hence, a rise in interest rate reduces stock prices from the perspective of asset portfolio allocation. In addition, an increase in interest rates affects the rms protability owing to a higher cost of borrowing for the rms and thereby reduces its attractiveness to foreign investors. Accordingly, an increase in the interest rate worldwide as proxied by the FFR reduces the Malaysian stock prices via reduces rms protability and in turn adversely affects the FPI. From the theoretical perspective, the effects of currency uctuations may be positively or negatively related to stock prices. For instance, when the currency depreciates, a rise in exports may increase a rms protability and thereby increasing the value of its stock. Conversely, a currency appreciation reduces a rms protability via higher import prices and therefore reduces the value of the stock. Finally, the stock market is hypothesized to have a positive effect on NFPI. Consistent with nancial economics tenet, an increase in either the composite or the Shariah index signals an economic growth and hence, is more attractive to international investors. 4. Data and empirical framework In this section, the sources of data and the empirical framework employed in the study are highlighted. The study adopts the (ARDL) approach to cointegration to assess the long-run equilibrium between the three markets and FPI. The variance decompositions (VDCs) and impulse-response functions (IRFs) are also employed to further evaluate the relative strength of the markets in explaining the variations in FPI.

Islamic capital market

317

IMEFM 1,4

318

4.1 Data This study, is carried out in the context of Malaysia, for the period 1999:Q1 to 2006:Q4. The data utilized in this study are obtained from the BNM Statistical Bulletins, Bloomberg, econstats.com and International Financial Statistic (IFS) Report published by the International Monetary Fund (IMF). Consistent with Baek (2006), the FPI variable is measured in terms of the net foreign purchases of domestic securities less net domestic purchases of foreign securities. The goods market is represented by real income (Y), while the money market variables are real broad-money supply (M2) and (TBR). In order to examine the effects of both conventional and Islamic securities market on NFPI, we have included both (KLCI) and Kuala Lumpur Shariah Index (KLSI) in our empirical models. The US (FFR) and the real effective exchange rate (REER) are included as they are found to be signicant variables in capital ows to emerging stock markets (Baek, 2006). The data description and its sources are reported in Table I. Except for TBR and FFR, all the data are transformed into natural logarithms. 4.2 Empirical framework A battery of time series techniques are used to empirically explore the dynamic interrelationships between the NFPI and the three-market (the goods, money and securities). The ARDL model is employed to empirically examine the long-run relationship among the variables, while the vector error correction model (VECM) is used to explore the short-and long-run dynamics between the NFPI and the three-market in Malaysia. Finally, the (VDCs) and (IRFs) are adopted to investigate the relative strengths of the causalities among the variables beyond the sample period.
Variable Description NFPI Y M2 TBR REER Net foreign portfolio investments Real income Real broad-money supply Interest rate Real effective exchange rate Measurement Net receipts of foreign portfolio less net payments for foreign portfolio GDP deator with 2000 as the base year Money supply M2 Three-month treasury bill rate The weighted average of the Malaysian exchange rate versus other major currencies calculated using the value of Malaysias trade with the respective countries and areas as its weights adjusted for ination rate differences A broad-based capitalization-weighted index of 100 stocks designed to measure the performance of Bursa Malaysia. The index has a base value of 95.83 as of January 3, 1977 A weighted average index with components comprising securities from the main board which have been approved by the Shariah advisory council The US Federal Funds rate Source BNM IFS IFS IFS IFS

KLCI

Kuala Lumpur composite index

Bloomberg

KLSI *

Kuala Lumpur Shariah Index Federal Funds rate

Bloomberg

Table I. Data description and sources

FFR

econstats.com

Note: *Since the KLSI index was launched in March 1999, the rst quarterly data is taken from April 1999

4.2.1 ARDL bound testing approach. To examine the relationship between (FPI) and the goods, money and securities markets, this study employs the newly proposed ARDL bound testing approach to cointegration (see Pesaran et al., 2001), which involves estimating the conditional error correction version of the ARDL model. The choice of ARDL approach in this study is based on consideration of cointegration analysis are unbiased and efcient given the fact that, rst, it can be applied to a small sample size study (Pesaran et al., 2001) and therefore conducting bounds testing will be appropriate for the present study. Second, it estimates the short and long-run components of the model simultaneously, removing problems associated with omitted variables and autocorrelation, and third, the ARDL method can distinguish between dependent and independent variables (Narayan, 2004). The ARDL models for the conventional and Shariah Indexes used in this study can be written as follows: NFPIt a0 a1 Y t a2 M2t a3 TBRt a4 KLCIt a5 FFRt a6 REERt et 1:1 NFPIt b0 b1 Y t b2 M2t b3 TBRt b4 KLSIt b5 FFRt b6 REER 1t 1:2 where NFPIt is the NFPI at time t, Yt is a the real income, M2t is broad-money supply, TBRt is the three-month treasury bill rate, KLCIt and KLSIt are the KLCI and Kuala Lumpur Shariah Index, respectively, FFRt is the US Federal Fund rate, REERt is the REER, et and e t are error terms for each model. The error correction version of ARDL framework pertaining to the variables in the equations (1.1) and (1.2) can be reproduced as follows: DNFPIt d0
p X i1 p X i0 p X i0

Islamic capital market

319

1i DNFPIt2i

p X i0

fi DY t2i

p X i0 p X i0

wi M2t2i ci DFFRt2i
2:1

gi DTBRt2i

p X i0

mi DKLCIt2i

ti DREERt2i l1 NFPIt21 l2 Y t21 l3 M2t21 l4 TBRt21

l5 KLCIt21 l6 FFRt21 l7 REERt21 u1t

p X i1 p X i0 p X i0 p X i0 p X i0

DNFPIt d0

1i DNFPIt2i

fi DY t2i

wi M2t2i ci DFFRt2i
2:2

p X i0 p X i0

gi DTBRt2i

mi DKLSIt2i

ti DREERt2i l1 NFPIt21 l2 Y t21 l3 M2t21 l4 TBRt21

l5 KLSIt21 l6 FFRt21 l7 REERt21 u1t

IMEFM 1,4

320

In the above equation, the terms with the summation signs represent the error correction dynamic while the second part (term with ls) correspond to the long run relationship. The null of no cointegration in the long run relationship is dened by H 0 : l1 l2 l3 l4 l5 l6 l7 0 is tested against the alternative of H0: l1 l2 l3 l4 l5 l6 l7 0; by the means of familiar F-test. However, the asymptotic distribution of this F-statistic is non-standard irrespective of whether the variables are I(0) or I(1). Pesaran et al. (1996) have tabulated two sets of appropriate critical values. One set assumes all variables are I(1) and another assumes that they are all I(0). This provides a bound covering all possible classications of the variables into I(1) and I(0) or even fractionally integrated. If the F-statistic lies above the upper bound level, the null is rejected, which indicates the existence of cointegration. While if the F-statistic falls below the bound level, the null cannot be rejected, which supporting no cointegration exist. If, however, it falls within the band, the result is inconclusive. Finally, in order to determine the optimal lag-length incorporated into the model and to select the ARDL model to be estimated, the study employs the Schwarz Bayesian Criterion (SBC). Since our study utilizes quarterly data with only 36 numbers of observations, the possible optimal lag-length to be considered is only 2. 4.2.2 VECM framework. To examine the short and long-run relationships among the variables, the study employs the (VECM) framework. The VECM regresses the changes in the both dependent and independent variables on lagged deviations. The multivariate causality test based on VECM can therefore be formulated as follows: DZ t d Gi DZ t21 . . .. . . Gk DZ t2k PZ t2k 1t 3

where Zt is an n 1 vector of variables and d is an n 1 vector of constant, respectively. In our case, Z t NFPI; Y; M; TBR; KLCI=KLSI; FFR; REER: G is an n n matrix (coefcients of the short run dynamics), P ab0 where a is an n 1 column vector (the matrix of loadings) represents the speed of short run adjustment to disequilibrium and b0 is an 1 n cointegrating row vector (the matrix of cointegrating vectors) indicates the matrix of long run coefcients such that Zt converge in their long run equilibrium. Finally, e t is an n 1 vector of white noise error term and k is the order of autoregression. A test statistic is calculated by taking the sum of the squared F-statistics of G and t-statistics of P. The multivariate causality test is implemented by calculating the F-statistics (Wald-test) based on the null-hypothesis that the set of coefcients (G) on the lagged values of independent variables are not statistically different from zero. If the null-hypothesis is not rejected, then it can be concluded that the independent variables do not cause the dependent variable. On the other hand, if P is signicant (that is different from zero) based on the t-statistics, then both the independent and dependent variables have a stable relationship in the long run. 4.2.3 VDCs and IRFs. Apart from the above battery of time series techniques, the study also generates (VDCs) and (IRFs) to further delve into the dynamics interaction among the variables. The VDCs enable us to examine the out-of sample causality among the variables in the VAR system. It measures the percentage of the forecast error of variable that is explained by another variable. Precisely, it indicates the relative impact that one variable has on another variable. At the same time, it provides information on how a variable of interest responds to shocks or innovations in

other variables. Thus, in our context, it allows us to explore the relative importance of goods, money and securities markets in accounting for variations in FPI. To interpret economic implications from VDCs ndings, the Sims (1980) innovation accounting procedure is employed. This procedure involves the decomposition of forecast error variance of each variable into components attributable to its own innovations and to shocks of other variables in the system. On the other hand, the IRFs (also known as innovation accounting in the literature) allow us to trace temporal responses of variables to its own shocks and shocks in other variables. In our context, from the IRFs we can assess the direction, magnitude and persistent of FPI responses to innovations in the goods, money and securities markets. 5. Empirical results and analysis In estimating the short and long-run relationships between NFPI and the goods, money and securities markets in Malaysia, we need to determine the lag-length of the rst-differenced variables. Bahmani-Oskooee and Bohl (2000) have shown that the results of this rst step are usually sensitive to the lag-length. To verify this, in line with Bahmani-Oskoee and Wing Ng (2002), we impose the optimal lag length of two on the rst difference of each variable to compute the F-statistics for the joint signicance of lagged levels of variables for our equations. The computed F-statistics for each lag-length of the conventional and Shariah indexes are reported in Table II along with the critical values at the bottom of the table. As reported, the test outcome of the signicance levels for the ARDL models varies with the choice of lag-length. The computed F-statistics are insignicant when the order of lag 1 for both models. However, for the lag-length 2, the computed F-statistics are signicant at least at 95 per cent and 90 per cent levels for conventional and Shariah indexes, respectively. This suggests that there seems to be a cointegration among the selected variables in both conventional and ICMs. These results are considered as preliminary and thus indicate that in estimating our equations we must retain the lagged level of variables. The next step involves estimating equations (2) and (3) using the appropriate lag-length selection criterion based on the Schwarz Bayesian Criterion (SBC). Based on Table III, the result provides evidence that the capital market in Malaysia (both Islamic and conventional) seems to be signicant in attracting FPI in Malaysia for the period of analysis. As hypothesized, the coefcients for both KLCI and KLSI are found to be positive suggesting that favourable conditions in securities markets (both Islamic and conventional stock markets) are signicant in attracting FPI in Malaysia. This nding

Islamic capital market

321

Order of lag 1 2

Model 1: conventional stock market 2.107 4.008 * *

Model 2: Islamic stock market 1.456 3.962 * Table II. F-statistics for testing the existence of a long-run equation

Notes: The relevant critical value bounds are taken from Narayan (2004) [Case II with a restricted intercept and no trend and number of regressors 6]. They are 3.686-5.310 at the 99 per cent; 2.696-3.963 at the 95 per cent; and 2.264-3.369 at the 90 per cent signicance levels, respectively. *and * * denotes that F-statistics falls above the 90 and 95 per cent upper bound, respectively

IMEFM 1,4

Regressor Y M2 FFR TBR KLCI KLSI REER Constant

Model 1: conventional stock market [0,1,0,1,1,0,0] 0.6300 (0.2372) 2 0.1918 (20.3858) 2 0.0599 (21.6987) 0.2946 (1.4667) 1.2367 * * (2.6062) 2 3.1450 * (21.9638) 3.3370 (0.2214)

Model 2: Islamic stock market [0,1,0,1,1,0,0] 0.5710 (0.2239) 20.0482 (2 0.1034) 20.6346 * (2 1.8677) 0.2641 (1.3582) 2 .2814 * * (2.9884) 22.5922 (2 1.6334) 1.3833 (0.0951)

322
Table III. Long-run coefcient estimates of net foreign portfolio investments

Notes: Figures inside the parentheses are the value of t-ratios. *, * * and * * * signicant at the 1, 5 and 10 per cent, respectively

concurs with those of Knight (1998), Henry (2000) and Durham (2004), which document that stock market has particular relevance to FPI. Although, there seems to be some considerable discrepancies in terms of stock market development across countries, Durham (2004) highlights Henrys (2000) hypothesis that stock market liberalization boosts prices and private investment growth via foreign inow. Our analysis further involves the VECM framework to regress the changes in both dependent and independent variables on lagged deviations. The estimates of the error correction representations selected by the SBC are in turn presented in Table IV. The long-run coefcients reported for both models involving KLCI and KLSI as in Table III
Model 1: conventional stock market [0,1,0,1,1,0,0] 0.0180 (0.0726) 23.0750 (21.5080) 1.0856 (0.4854) 20.1426 (20.0420) 1.9375 (0.5459) 20.9005 * (22.0514) 0.2102 (1.0493) 20.2781 (21.4663) 0.0794 (0.4642) 1.2405 * (1.7868) 0.2185 (0.3070) 21.6066 (20.4407) 1.8358 (0.5033) 20.0215 (20.2143) 20.01462 * * * (2 2.9762) 0.6197 4.3748 1.9584 Model: Islamic stock market [0,1,0,1,1,0,0] 0.0194 (0.0756) 2 3.0095 (2 1.4618) 0.8985 (0.3978) 0.1572 (0.0470) 1.8061 (0.4945) 2 0.9187 * (22.0959) 0.1405 (0.8587) 2 0.2809 (2 1.4293) 0.07928 (0.4683) 1.4659 * * (2.2601) 0.0806 (0.1091) 2 1.1959 (2 0.3314) 2.1314 (0.5648) 2 0.0222 (2 0.2190) 2 0.0452 * * (22.8851) 0.6204 4.3857 1.8906

Regressor DNFPIt-1 DY DYt-1 DM2 DM2t-1 DTBR DTBRt-1 DFFR DFFRt-1 DKLCI DKLCIt-1 DKLSI DKLSIt-1 DREER DREERt-1 Constant ECTt-1 Adjusted R2 F-statistics DW-statistics

Table IV. Error correction representation of ARDL model (dependent variable is DlnNFPIt)

Notes: Figures inside the parentheses are the value of t-ratios. *, * * and * * * signicant at the 1, 5 and 10 per cent, respectively

are employed to generate the error correction terms. The adjusted-R2 values are 0.62 for both markets, suggesting that such error correction models t the data reasonably well. In addition, the computed F-statistics clearly reject the null hypothesis that all regressors have zero coefcients for both cases. More importantly, the error correction terms (ECTs) carry the correct negative signs and are signicant. This therefore, substantiates our earlier ndings of the existence of cointegration between FPI and the goods, money and securities markets. Furthermore, the speed of adjustment for both models is about 10 percent. This indicates that last period disequilibrium is, on the average, corrected by about 4.5 percent in the following quarter. We then proceed to examine the stability of the long-run coefcients together with the short-run dynamics. Following Pesaran and Pesaran (1997), we apply the cumulative sum of recursive residuals (CUSUM) and the CUSUM of square (CUSUMSQ) tests proposed by Brown et al. (1975). The tests are employed for both models. As highlighted by Bahmani-Oskooee and Ng (2002), the CUSUM test is employed based on the rst set of observations and is updated recursively and plotted against the break points. If the plot of the CUSUM statistics is found to be within the critical bounds of 5 per cent level, the null hypothesis that all coefcients in the error correction models as in equations (2) and (3) are stable cannot be rejected. On the other hand, if the lines are found to be crossed, the null hypothesis of coefcient constancy can therefore be rejected at 5 per cent signicance level. A similar procedure is employed to carry out the CUSUMSQ test, which is based on the squared recursive residuals. Based on the graphical representations for CUSUM and CUSUMSQ tests for both models with the conventional and Islamic stock markets, respectively, as in Figure 1, the results indicate no evidence of any signicant structural instability. As mentioned earlier, the results obtained under VECM analysis are restricted to within-sample tests (Masih and Masih, 1997). In order to examine the relative strength of the causalities among the variables, we apply the (VDCs) and impulse-responses functions (IRFs) analyses. As reported in Table V, the results for VDCs for Model 1, involving the conventional stock market indicates that in the three-year horizon, interest rate accounts for only 23.44 per cent of the shocks in the NFPI compared to the contributions of the innovations for money supply M2 (10.06 per cent), Y (9.43 per cent), REER (7.62 per cent), KLCI (4.34 per cent) and FFR (1.79 per cent). This implies relative exogeineity of interest rate (TBR) compared with other variables within the system. Our ndings are further substantiated by the examining the IRFs for Model 1. The IRFs basically map out the response path of the dependent variable in the vector autoregression (VAR) system to shocks on the error term (Gujarati, 1995). From Figure 2, the IRFs suggest that the independent variables are not signicant in affecting the NFPI in the short run. This nding lends support to the ndings of Baek (2006), Bayoumi et al. (2003), and Eichengreen and Mody (1998), that provide empirical evidence that FPI in emerging economies cannot be fully explained by domestic and external economic factors. Rather, market mood or sentiment is found to be increasingly signicant in identifying causes for capital ows in emerging economies (Baek, 2006; Claessen et al., 1995). Similar observations can also be noted for Model 2, involving ICM. As evident in the VDCs, the interest rate accounts for only 24.64 per cent of the shocks in the NFPI compared to the contributions of the innovations for money supply M2 (9.32 per cent), Y (8.08 per cent), REER (7.53 per cent), KLCI (6.12 per cent) and FFR (1.83 per cent) in

Islamic capital market

323

IMEFM 1,4
15 10 5 0 5 10 15 1999Q2 Model 1: Conventional Stock Market Plot of Cumulative Sum of Recursive Residuals

324

2000Q3 2001Q4 2003Q1 2004Q2 2005Q3 The straight lines represent critical bounds at 5% significance level Plot of Cumulative Sum of Squares of Recursive Residuals

2006Q4

1.5 1.0 0.5 0.0 0.5 1999Q2

2000Q3

2001Q4

2003Q1

2004Q2

2005Q3

2006Q4

The straight lines represent critical bounds at 5% significance level Model 2: Islamic Stock Market Plot of Cumulative Sum of Recursive Residuals

15 10 5 0 5 10 15 1999Q2

2000Q3 2001Q4 2003Q1 2004Q2 2005Q3 The straight lines represent critical bounds at 5% significance level Plot of Cumulative Sum of Squares of Recursive Residuals

2006Q4

1.5 1.0 0.5 0.0 0.5 1999Q2

2000Q3

2001Q4

2003Q1

2004Q2

2005Q3

2006Q4

The straight lines represent critical bounds at 5% significance level

Figure 1. Cusum and cusumsq test

Horizon (quarterly) Model 1: conventional stock market 1 2 4 8 12 1 2 4 8 12

NFPI 100.00 77.25 51.86 46.53 43.31 NFPI 100.00 76.95 50.15 45.55 42.47

Y 0.00 1.53 6.05 8.01 9.43 Y 0.00 1.27 5.01 6.47 8.08

Explained by shocks in: M2 TBR KLCI REER 0.00 1.47 9.53 9.42 10.07 M2 0.00 2.02 8.92 8.81 9.32 0.00 14.70 21.43 23.30 23.44 TBR 0.00 14.62 23.36 24.50 24.64 0.00 0.00 4.52 4.57 4.34 KLSI 0.00 0.22 5.68 6.52 6.12 0.00 5.06 4.62 6.28 7.62 REER 0.00 4.86 4.90 6.21 7.54

FFR 0.00 0.00 1.99 1.89 1.79 FFR 0.00 0.05 1.97 1.94 1.83

Islamic capital market

325

Model 2: Islamic stock market

Table V. Variance decompositions

the 12-quarter horizon. As in Model 1, this implies the relative exogeineity of interest rate (TBR) compared to other variables within the system. The IRFs as in Figure 2 also indicate the non-signicance of all the variables for goods market, money market and securities market in explaining the changes in NFPI. Our results therefore augur well with the results of Baek (2006) that domestic economic conditions and external factors (i.e. the US FFR) seem to have a negligible role in attracting portfolio investment into the Asian emerging markets. 6. Conclusion This paper investigates the short and long-run relationships between (NFPI) and the goods, money and securities markets in Malaysia for the period 1999:Q1 to 2006:Q4. The emphasis of the paper is to identify the signicance of all these markets in attracting NFPI. We also try to make a comparison between the roles of conventional and ICMs in attracting NFPI during the period of analysis. The results of this study indicate that changes in the NFPI cannot be fully explained by the real sectors or the fundamentals of the economy. Among the three-market investigated (i.e. the goods, money and securities markets), the securities market seems to be the most signicant market in attracting FPI. One possible explanation for this is that, similar to other countries like Korea, Thailand and Indonesia, the securities in Malaysia are issued by private rms instead of the government. In addition, the international Muslim investors seem to also be attracted to Shariah-compliant instruments offered by Malaysian ICM. As highlighted by Baek (2006), the market activities are not closely monitored by the government and therefore could easily be susceptible to other factors like market sentiment or mood compared to economic fundamentals. Our ndings seem to suggest that NFPI are similarly affected by both conventional and ICMs. This calls for a further re-evaluation of policies designed by government in promoting the Malaysian capital markets (both Islamic and conventional) to attract more FPI into the economy. In order to compete with other emerging markets, either within the ASEAN region or other emerging markets, policy makers in Malaysia must send the right signals about domestic economic and institutional reforms to further attract international investors.

IMEFM 1,4
Model 1: Conventional Stock Market
Response of NFPI to NFPI 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 2 3 4 5 6 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 Response of NFPI to FFR Response of NFPI to TBR 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 Response of NFPI to KLCI Response of NFPI to Y 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 Response of NFPI to REER Response of NFPI to M2

326

Model 2: Islamic Stock Market

Response of NFPI to NFPI 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 2 3 4 5 6 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 Response of NFPI to FFR Response of NFPI to TBR 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 Response of NFPI to KLCI Response of NFPI to Y 0.6 0.4 0.2 0.0 0.2 0.4 0.6 1 2 3 4 5 6 Response of NFPI to REER Response of NFPI to M2

Figure 2. Impulse-response functions

In promoting Malaysia as the International Islamic Financial Hub, Malaysia to a certain extent has been successful in attracting the FPI. However, further efforts are needed in designing policies to attract portfolio investments from other countries. The ndings of study are based on the methodology outlined above. In assessing the roles of the three markets in attracting (FPI), the study mainly focuses on the conventional markets. However, for the securities market, both Islamic and conventional markets are evaluated. For more reliable and robust ndings, further studies should also investigate the signicance of Islamic money market in attracting FPI.

Islamic capital market

327

Notes 1. In comparison with other markets, Malaysia was ranked twenty-third in the world in 2004, being the largest market in ASEAN (Association of Southeast Nations) and is currently ranked eighth in Asia. If 1996 was used as yardstick, the KLSE would be one of the largest markets in the world (Bank Negara Malaysia, 2005). 2. For a detailed information, see http://islamic-world.net/Islamic-state/malay_islamcap market.htm

References Baek, In-Mee (2006), Portfolio investment ows to Asia and Latin America: pull, push or market sentiment?, Journal of Asian Economics, Vol. 17, pp. 363-73. Bahmani-Oskooee, M. and Bohl, M.T. (2000), German monetary unication and the stability of the German M3 money demand function, Economics Letters, Vol. 66, pp. 203-8. Bahmani-Oskooee, M. and Ng, R.C.W. (2002), Long-run demand for money in Hong Kong: an application of the ARDL model, International Journal of Business and Economics, Vol. 1 No. 2, pp. 147-55. Bank Negara Malaysia (2005), Annual Reports (various issues). Bayoumi, T., Fazio, G.K.M. and Macdonald, R. (2003), Fatal attraction: a new measure of contagion, IMF Working Paper, WP/03/80, International Monetary Fund, Washington, DC. Brennan, M.J. and Cao, H. (1997), International portfolio investment ows, Journal of Finance, Vol. 52, pp. 1851-80. Brown, R.L., Durbin, J. and Evans, J.M. (1975), Techniques for testing the constancy of regression relations over time, Journal of the Royal Statistical Society, Vol. 37, pp. 149-92. Chen, N.F., Roll, R. and Ross, S. (1986), Economics forces and the stock market, Journal of Business, Vol. 59 No. 3, pp. 383-403. Claessens, S., Dasgupta, S. and Glen, J. (1995), Return behaviour in emerging stock markets, World Bank Economic Review, Vol. 9, pp. 131-52. Dhakal, D., Kandil, M. and Sharma, S.C. (1993), Causality between the money supply and share prices: a VAR investigation, Quarterly Journal of Business and Economics, Vol. 32 No. 3, pp. 52-74. Durham, J.B. (2004), Absorptive capacity and the effects of foreign direct investment and equity foreign portfolio investment on economic growth, European Economic Review, Vol. 48, pp. 285-306.

IMEFM 1,4

328

Eichengreen, B. and Mody, A. (1998), What explains changing spreads on emerging-market debt? Fundamentals or market sentiments?, NBER working paper, No 6408, National Bureau of Economic Research, Cambridge, MA. Geske, R. and Roll, R. (1983), The scal and monetary linkage between stock returns and ination, Journal of Finance, Vol. 38, pp. 7-33. Goldstein, I. and Razin, A. (2006), An information-based trade off between foreign direct investment and foreign portfolio investment, Journal of International Economics, Vol. 76, pp. 271-95. Gordon, R.H. and Bovenberg, L. (1996), Why is capital so immobile internationally? possible explanations and implications for capital income taxation, American Economic Review, Vol. 86, pp. 57-75. Grinblatt, M., Titman, S. and Wermers, R. (1995), Momentum investment strategies, portfolio performance and herding: a study of mutual fund behaviour, American Economic Review, Vol. 85, pp. 1088-105. Gujarati, D. (1995), Basic Econometrics, McGraw-Hill, New York, NY. Henry, P.H. (2000), Do stock market liberalizations cause investment booms?, Journal of Financial Economics, Vol. 58 No. 2, pp. 301-34. Ibrahim, M. (2002), Volatility interactions between stock returns and macroeconomic variables Malaysian evidence, Savings and Development, Vol. 26 No. 2, pp. 194-483. Ibrahim, I. and Jusoh, M.A. (2001), The causes of stock market volatility in Malaysia, Proceedings of the Malaysian Finance Association 3rd Annual Symposium, Malaysian Finance Association and International Islamic University Malaysia, Kuala Lumpur. Kaminsky, G., Lyons, R. and Schmukler, S. (1999), Managers, investors and crises: mutual fund strategies in emerging markets, World Bank Policy Research Working Paper No. 2399, World Bank, Washington, DC. Kang, J.K. and Stulz, R.M. (1997), Why is there a home bias? An analysis of foreign portfolio equity ownership in Japan, Journal of Financial Economics, Vol. 46, pp. 3-28. Kim, W. and Wei, S-J. (2002), Foreign portfolio investors before and during a crisis, Journal of International Economics, Vol. 56, pp. 77-96. Knight, M. (1998), Developing countries and the globalization of nancial markets, World Development, Vol. 26, pp. 1185-200. La Porta, R., Lopez-De-Silanes, F., Shleifer, A. and Vishny, R. (1997), Legal determinants of external nance, Journal of Finance, Vol. 52 No. 3, pp. 1131-50. Liljeblom, E. and Stenius, M. (1997), Macroeconomic volatility and stock market volatility: empirical evidence on Finnish data, Applied Financial Economics, Vol. 7, pp. 419-26. Liljeblom, E. and Lound, A. (2005), Determinants if international portfolio investment ows to a small market: empirical evidence, Journal of Multinational Financial Management, Vol. 15, pp. 211-33. Masih, A.M. and Masih, R. (1997), A comparative analysis of the propagation of stock market uctuations on alternative models of dynamic causal linkage, Applied Financial Economics, Vol. 7, pp. 59-74. Mukherjee, T.K. and Naka, A. (1995), Dynamic relations between macroeconomic variables and the Japanese stock market: an application of a vector error-correction model, Journal of Financial Research, Vol. 18 No. 2, pp. 223-37. Narayan, P.K. (2004), Reformulating critical values for the bounds F-statistics approach to cointegration: an application to the tourism demand model for Fiji, Discussion Paper No. 02/04, Department of Economics, Monash University, Melbourne.

Pesaran, M.H. and Pesaran, B. (1997) Working with Microt 4.0: Interactive Econometrics Analysis, Oxford University Press, Oxford. Pesaran, M.H., Shin, Y. and Smith, R.J. (1996), Testing for the existence of a long-run relationship, DAE working paper no. 9622, Department of Applied Economics, University of Cambridge, Cambridge. Pesaran, M.H., Shin, Y. and Smith, R.J. (2001), Bounds testing approaches to the analysis of level relationships, Journal of Applied Econometrics, Vol. 16, pp. 289-326. Rose, A. (2005), Which international institutions promote international trade?, Review of International Economics, Vol. 13 No. 4, pp. 682-98. Security Commission (2007), Shariah tradeable index for global investors, Quarterly Bulletin of Malaysian Islamic Capital Market, Vol. 2 No. 2, pp. 5-6. Sim, C.A. (1980), Macroeconomics and reality, Econometrica, Vol. 48 No. 1, pp. 1-49. Wongbangpo, P. and Sharma, S.C. (2002), Stock market and macroeconomic fundamental dynamic interactions: ASEAN-5 countries, Journal of Asian Economics, Vol. 13 No. 1, pp. 27-51. World Federation of Exchanges (2006), Annual Reports (various isssues). Further reading International Monetary Fund (2006), International Financial Statistic Online, available at: www. imfstatistics.org Islamic Capital Market (2000), available at: http://islamic-world.net/Islamic-state/ malay_islamcapmarket. htm (accessed 12 April). Corresponding author M. Shabri Abd. Majid can be contacted at: mshabri@iiu.edu.my

Islamic capital market

329

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com Or visit our web site for further details: www.emeraldinsight.com/reprints